Performing Audit Accounting Temtim

For TVET Level

Chapter One
Identifying Fundamentals of Auditing
Learning Objectives:
Auditing
After studying is concerned
this chapter, with
students should verification
be able to: of accounting and financial records with a view to determining their
accuracy and reliability. Auditing involves examination of books, accounts, and financial statements with the
 Define auditing and describe the required parts of the definition;

main objective of determining whether this information reflects the economic events that occurred during the
Identify code of ethics for auditors correctly;
 accounting
Identify period.
the responsibilities of management and auditors correctly;
 Distinguish between different types of audits and auditors, based on standardized classifications;
 Auditors
Describe the need provide assurance
for financial services
statement audits, based about financialneeds
on the information and ofnonfinancial
users; statement information, including audits
 of historical financial statements. Auditors are valued
Distinguish between accounting and auditing emphasizing on objectives and methodology. because of their technique, knowledge and
 independence,
Describe the ten Generallyand theyAuditing
Accepted also assist companies
Standards in improving operations and internal controls. Auditors often
properly (GAAS);
 make
Identify suggestions
the format of auditor’sthat improve
standard profitability
report based by reducing costs, including the reduction of errors and fraud,
on their content.
and by improving operational efficiency.
This chapter will start discussion by defining auditing and identifying the different types of audits and
auditors, moreover, the auditors’ code of professional ethics and Generally Accepted Auditing Standards will
be discussed in detail.
1.1 Task 1 Defining Auditing:
Auditing is an exercise whose objective is to enable Auditors to express an opinion whether the financial statements give a true
and fair view (or equivalent) of the entity’s affairs at the period end (balance sheet) and its profit and loss (or income and
expenditures) for the period then ended and have been properly prepared in accordance with the applicable recording framework,
where statutory or other requirements prescribe the term, whether the financial statements “present fairly. (The Accounting
Principles Board (APB)).

Auditing is the accumulation and evaluation of evidences 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.
(Arens & Loebbecke).

Auditing is the examination, by an independent accountant, of the financial data, accounting records, business
documents, and other pertinent documents of an organization in order to attest to the reasonableness of its financial
statements. (Microsoft Encarta, 2005).

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 American Accounting Association, committee
on Basic Auditing concepts)
These definitions include several key words and phrases. They tell us that to do an audit there must be:
 Verifiable information and established criteria.
To do an audit there must be information in a verifiable form and some standards by which the
auditor can evaluate the information. Auditors routinely audit quantifiable information, including
companies’ financial statements and income tax returns. Auditors also perform audits of more
subjective information, such as efficiency of manufacturing operations.

The criteria for evaluating information also vary depending on the information being audited. For example,
in the audit of historical financial information, the criteria are usually generally accepted accounting
principles (GAAP).
 Accumulating and evaluating evidence
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Evidence is any information used by the auditor to determine whether the information being audited
is stated in accordance with the established criteria. Evidence can be oral testimony of the auditee
(Client), observations by the auditor, and written communication with outsiders.
It is important to obtain a sufficient quality and volume of evidence to satisfy the purpose of the audit.
Determining the type and amount of evidence necessary and evaluating whether the information corresponds
to the established criteria is a critical part of every audit.
 Competent, independent person
Competence refers to the qualification of the auditor to understand the criteria used and the ability to
know the type and amount of evidence to accumulate to reach at the proper conclusion after a careful
examination of evidences.
Independence refers to the unbiased mental attitude of the auditor. Although absolute independence
is impossible, auditors strive to maintain a high level of independence to keep the confidence of users
relying on their report. Internal auditors try to keep their independence by reporting directly to top
management.
 Reporting
Preparation of audit report is the final stage in audit process. Audit report is a communication of
auditor’s findings to users. Though reports differ in nature, they all must inform readers the degree of
correspondence between information 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 small department’s effectiveness.

1.2 Economic Demand for Auditing

In today’s business world information becomes the powerful weapon. Its consequence may be incalculable
reward if it is accurate and highly destructive if it is inaccurate. Thus, information is considered as one form
of risk.
Information risk reflects the possibility that the information upon which the business risk decision was
made inaccurate. A likely cause of information risk is the possibility of inaccurate financial statements.
There are different causes of information risk.
1. Remoteness of information – the complexity of the business environment makes first hand
information scarce and thereby increases information risk. In the modern world, it I virtually
impossible for a decision maker to have first hand knowledge about the organization with which he or
she does business. Information provided by other s must be relied upon. When information is
obtained from others, the likelihood of it being intentionally or unintentionally misstated increases.
2. Biases and motives of the provider – if information is provided by someone whose goals are
inconsistent with those of the decision maker; the information may be biased in favor of the provider.
3. Voluminous data – As organizations become larger, so does their exchange transactions. This
increases the likelihood that improperly recorded information will be included in the records.
4. Complex exchange transactions – This typically refers to the difficulty of correct accounting
treatments in some complex transactions. Such as the acquisition of one entity by another, proper
combining and disclosing the result of operations of subsidiaries in different industry. The more
exchange transactions among organizations become, the greater the risk of inaccuracy of information.
5. 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.
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Reducing information Risk.

To reduce information risk:
1. Users have to verify the information
2. User shares information risk with management through law suit against management
3. Audited financial statements. It is the most common way of obtaining reliable information.
1.2.1 Importance of Audit
The decisions that are made depending on financial statements are usually critical to stakeholders. Decisions
that require the commitment of huge sum of money such as buying of shares, diverting business, setting price
of a share, granting bank loans etc hangs on financial statements. Thus, any mistakes and errors in the
reporting of financial statements may have adverse consequences. However, statements are highly vulnerable
to mistakes. The report may:
 Contain errors
 Not disclose frauds
 Be inadvertently misleading
 Be deliberately misleading
 Fail to disclose relevant information
 Fail to conform to regulation
Cognizant of this fact, stakeholders and accountants are worried about the credibility of reports. Thus owners
appoint, as a solution, independent person called Auditor to investigate the report and report on his/her
findings.
The other importance is that large organizations with complex operations summarize accounts of subsidiaries
with differing conventions, legal system and accounting control system. The examination of such accounts
by independent expert is of benefit to those who control and operate such organizations as well as to owners
and outsiders.

The other notable importance of auditing is that it checks the conformity of accounting practices and reports
to various requirements. To state few, the requirement of financial reporting standards (FRS) and the still
relevant statements of standard accounting practice (SSAPs) are the major ones.
1.2.2 Objectives of Auditing
The auditor should be an independent person who is appointed to investigate the organization, its records and
the financial statements prepared from them, and thus produce an opinion in the accuracy and correctness of
financial statements. Thus auditing objectives may be divided into primary and subsidiary objectives.
 Primary Objectives
To produce a report by the auditor of his opinion of the truth and fairness of financial statements so that any
person reading and using them can have a belief in them.
 Secondary Objectives
 To detect errors and frauds
 To prevent errors and frauds by deterrent and moral effect of the audit
 To provide spin-off effects. The auditor will be able to assist his client with accounting, systems,
taxation, financial and other problems (Advisory service).
1.3 Distinction between Auditing and Accounting
Many financial statement users and members of the general public confuse auditing with accounting. The
confusion results because most auditing is usually concerned with accounting information, and many
auditors have considerable expertise in accounting matters. Giving the title “Certified Public Accountant” to
many individuals who perform audit increases the confusion.
Accounting is the recording, classifying, and summarizing of economic events in a logical manner for the
purpose of providing financial information for decision-making. The function of accounting is to provide
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qualitative information in light of the principles and rules. Whereas, Auditing concern is in determining
whether the recorded information properly reflects the economic events that occurred during the accounting
period.
Because accounting rules are the criteria for evaluating whether the accounting information is properly
recorded, any auditor involved with this data must also thoroughly understand those rules. In context of
auditing the rules are Generally Accepted Accounting Principles (GAAP). Accountants also must understand
such rules. However the expertise (knowledge) that distinguishes accountants from auditors is in
accumulation and interpretation of audit evidence. Unlike accountants, auditors decide on audit procedures,
number and type of items to test and evaluate results.
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 Types of Audit and Auditors

1.4.1 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. There are
three types of audits that Certified Public Accountants (CPAs) can perform.
1. Financial Statement Audit – is conducted to determine the overall financial statements (the information
being verified) are stated in accordance with specified criteria, usually the GAAP. The financial
statements most often included are the statement of financial position (Balance Sheet), income statement,
and statement of cash flow, including accompanying footnotes (disclosures).
2. Operational Audit - is a review of nay part of an organization’s operating procedures and methods for
the purpose of evaluating efficiency and effectiveness. The aim of an operational audit is to improve
operations.
Since efficiency and effectiveness of operations are far more difficult to evaluate objectively in
operational audit and established criteria for evaluating the information is an extremely subjective,
operational audit is more like management consulting than what is generally regarded as auditing.
3. Compliance Audit – is used to determine whether the auditee is following specific procedures, rules, or
regulations set by some higher authority. The regulations may be set by the organization, the government
or legal and regulatory bodies. Results of compliance audits are generally reported to someone within the
organizational unit being audited rather than to external users.

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.
1. Independent Auditors - are responsible for auditing the published historical financial statements of all
publicly traded companies, most other reasonably large companies, and many smaller companies and non
commercial organizations. CPA firms must be licensed in order to engage in auditing activities. CPA
auditors are often called external auditors or Certified Public Accounting firms to distinguish them from
internal auditors.

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2. Government Auditors – are a nonpartisan agency in the legislative branch of the federal government.
They are responsible primarily to perform the audit functions for the congress. Much of the financial
statements prepared by government agencies are audited by government auditors before submitted to
congress. An increasing portion of the government auditors audit efforts has been devoted to evaluate the
operational efficiency and effectiveness of various federal programs, these government auditors are also
known as General accounting office auditors (GAOs). Besides, Internal Revenue Agents (IRAs) who
are tax auditors of the government are responsible to audit the taxpayers’ returns to determine whether
they have complied with the tax laws. The audits performed by the IRAs are solely compliance audits.
An auditor involved in these areas must have considerable tax knowledge and auditing skills to conduct
an effective audit. 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.

3. Internal Auditors - are employed by individual companies to audit for management and board of
directors. Their duties vary from company to company; many internal auditors are involved in
operational audit. To operate effectively, an internal auditor must be independent of the line functions in
an organization.

1.5 Auditor’s Professional Ethics

Ethics – can be defined broadly as a set of moral principles or values. Each of us has a set of values,
although we may not have considered them explicitly. Philosophers, religious organizations and other groups
have defined in various ways the idea sets of moral principles and values.
Examples of prescribed sets of moral principles or values at the implementation level include laws and
regulations, church doctrine, codes of business ethics for professional groups such as CPAs, and codes of
conduct within individual organizations.
Ethical behavior is necessary for a society to function in an orderly manner. The underlying reason for a high
level of professional conduct by any profession is the need for public confidence in the quality of services
rendered by the professions.
Most people define unethical behavior, as a conduct that differs from what they believe would have been
appropriate given circumstances. It is believed that there are two primary reasons why people act
unethically: the reasons are first when the person’s ethical standards are different from those of society as a
whole or second when the person chooses to act selfishly. The typical examples for the former include drug
dealers, bank robbers. The later behavior marks a considerable proportion; examples include political power
desire, cheating taxes.
An example of a prescribed set of principles that was developed by the Josephson Institute for Advancement
of Ethics. The Josephson Institute was established as a not-for-profit foundation to encourage ethical conduct
of professionals in the fields of government, law, medicine, business, accounting, and journalism.
The ten prescribed ethical principles are:
a. Honesty f. Caring for others
b. Integrity g. Respect for others
c. Promise keeping h. Responsible citizenship
d. Loyalty (fidelity) i. Pursuit of excellence
e. Fairness j. Accountability
The following are six core ethical values that the Josephson Institute associates with ethical behavior.
A. Trustworthiness includes honesty, integrity, reliability, and loyalty.
Honesty requires good faith intent to convey the truth.

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Integrity means that the person acts according to conscience, regardless of the situation.
Reliability means making all reasonable efforts to fulfill commitments.
Loyalty is a responsibility to promote and protect the interests of certain people and organization.
B. Respect includes notions such as civility, courtesy, dignity, tolerance, and acceptance.
A respectful person treats others with consideration and accepts individual differences and benefits
without prejudice.
C. Responsibility means being accountable for one’s actions and exercising restraints. Responsibility also
means pursuing excellence and leading by example, including perseverance and engaging in continuous
improvement.
D. Fairness and justice include issues of equality, impartiality, proportionality, openness, and due process.
Fair treatment means that similar situations are handed consistently.
E. Caring means being genuinely concerned for the welfare of others and includes acting altruistically and
showing benevolence.
F. Citizenship includes obeying laws and performing one’s share to make society work, including such
activities as voting, serving on juries, and conserving resources

Ethical Dilemmas
An ethical dilemma is a situation a person faces in which a decision must be made about the appropriate
behavior. A simple example include, finding a diamond ring, which necessitates deciding whether to attempt
to find the owner or to keep it, accepting money informally as a tip of corruption, killing or keeping alive the
patient who is in agony.
Auditors, accountants, and other business people face many ethical dilemmas in their business careers.
Dealing with a client who threatens to seek a new auditors unless an unqualified opinion (auditor’ opinion for
those organizations present their financial statements fairly) is issued presents a serious ethical dilemma if an
unqualified opinion is inappropriate. Deciding whether to confront a supervisor who has materially
overstated departmental revenues as a means of receiving a large bonus is difficult ethical dilemma.
Continuing to be a part of the management of a company that harasses and mistreats employees or treats
customers dishonestly is a moral dilemma, especially of the person has a family to support and the job
market is tight.
The common rationalizations of ethical dilemmas include:
1. Everybody does it – the argument that it is acceptable to falsify things because it is done by
everybody. Examples include, falsify tax returns, cheat on exams, or sell defective products.
2. If it’s Legal, it’s Ethical – using the argument that all legal behavior is ethical relies heavily on the
perfection of laws. Under this philosophy, one would have no obligation to return a lost object unless
the other person could prove that it was his or hers. Example, abortion.
3. Likelihood of Discovery and Consequences – this philosophy relies on evaluating the likelihood
that someone else will discover the behavior. Typically, the person also assesses the severity of the
penalty (Consequence) if there is a discovery. An example is deciding whether to correct an
unintentional over billing to a customer when the customer has already paid the full billing. If the
seller believes that the customer will detect the error and respond by not buying in the future, the
seller will inform the customer now; otherwise he/she will wait to see if the customer complains.

Resolving Ethical Dilemmas

In recent years, formal frameworks have been developed to help people resolve ethical dilemmas. The
purpose of such a framework is in identifying the ethical issues and deciding on an appropriate course of

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action using the person’s own values. The six-step approach that follows is intended to be a relative simple
approach to resolve ethical dilemma.
1. Obtain the relevant facts.
2. Identify the ethical issues from the facts.
3. Determine who is affected by the outcome of the dilemma and how each person or group is affected.
4. Identify the alternatives available to the person who must resolve the dilemma.
5. Identify the likely consequence of each alternative.
6. Decide the appropriate action.

Importance of ethical conduct in professions

The term profession means a responsibly for conduct (behavior) that extends beyond discharging own
responsibilities and beyond the requirements of society’s laws and regulations. This may involve personal
sacrifices. The central rationale behind code of conduct is getting Public Confidence. Public confidence is
more important for CPAs than other professions in that unlike other professions, users of CPAs works are the
general public even though they get their fees from their clients.
1.5.1 Code of Professional Conduct

A code of conduct can consist of general statements of ideal conduct or specific rules that define
unacceptable behavior. The advantage of general statements is the emphasis on positive The American
Institute of Certified Public Accountants (AICPA) code of professional conduct provides both general
standards of ideal conduct and specific enforceable rules of conduct. There are four parts to the code:

a- Principles In order of increasing

b- Rules of conduct specificity.
c- Interpretations of the rules of conduct
d- Ethical ruling
Code of Professional Conduct.
Ideal standards of ethical conduct stated in philosophical terms.
Principles

They are not enforceable

Minimum standards of ethical conduct stated as specific rules.
Rules of Conduct

They are enforceable

Interpretations of the rules of conduct by the AICPA division of Professional Ethics.

Interpretation of the They are not enforceable, but a practitioner must justify departure.
Rules of Conduct Published explanations and answers to questions about the rules of conduct submitted to the
AICPA by practitioners and others interested in ethical requirements.
Ethical Rulings
They are not enforceable, but a practitioner must justify departure.

I. Ethical principles
There are six principles of professional conduct.
1. Responsibilities – in carrying out their responsibilities as professionals, auditors should exercise
sensitive professional and moral judgment in all their activities.
2. The public interest – Auditors should accept the obligation to act in a way that will serve the public
interest, honor the public trust, and demonstrate commitment to professionalism.

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3. Integrity – To maintain and broaden public confidence, members should perform all professional
responsibilities with the highest sense of integrity.
4. Objectivity & Independence – An Auditor should maintain objectivity and be free of conflicts of
interest in discharging professional responsibilities. A member in public practice should be
independent in fact and appearance when providing auditing and other attestation services.
5. Due Care – An Auditor should observe the professional’s technical and ethical standards, strive, and
discharge professional responsibility to the best of the member’s ability.
6. Scope and nature of services – A member in public practice should observe the principles of the
code of professional conduct in determining the scope and nature of services to be provided.
The first five principles apply to all members of the AICPA auditors, both internal & external and
accountants; while the last one is applicable to those who make public practice.

II. Rules of Conduct and their Interpretations

They are explicit rules that must be followed by every CPA in the practice of public accounting. Rules are
the only enforceable part of the code, which are stated in more precise language than the section on
principles. It may not be necessary to follow all, but CPAs should follow most of the requirements.

Reading assignment: there are 11 rules of conduct and corresponding interpretations.

Enforcements
Failure to follow the rules can result in expulsion of AICPA, which is a weighty social sanction. However, it
doesn’t mean a CPA can’t practice public accounting.

III. Ethical Rulings

Are published explanations and answers to questions about the rules of conduct submitted to the AICPA by
practitioners and other interested in ethical requirements, They are not enforceable, but a practitioner must
justify departure.

1.6 Audit Objectives & Responsibilities

1.6.1 Audit Responsibilities
The objective of the ordinary audit of financial statements by the independent auditor is the expression of an
opinion on the fairness with which they present fairly, in all material respects, financial position, results of
operations, and its cash flows in conformity with GAAP. This emphasis on opinion of financial statements is
outlined in SAS (Statements of Auditing Standard)
Although the auditor is not an insurer or a guarantor of the fairness of the presentations, he/she has
considerable responsibility for notifying users whether the statements are properly stated. In case when
situations make difficult to draw conclusions, the auditor has the responsibility to notify the users through the
report.
Steps to develop specific audit Objectives

Understand objectives and responsible for the audit

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Know management assertions about accounts

Know general audit objectives for classes of

Transactions and accounts

Know specific audit objectives for classes of

Transactions and account
Understand objectives and responsibilities for the audit
As explained earlier, giving reasonable opinion on the presentation of financial statements is the objective of
auditing. Apart from this, the auditor should also understand the responsibilities of management and auditors.
A. Managements Responsibility
The management is responsible for:-
Adopting sound accounting policies
Maintaining adequate internal control
Making fair representation (assertions) in the financial statements.
Determining which disclosures to consider.
In fact, it is acceptable for the auditor to draft financial statements for clarification

B. Auditor's responsibilities
The auditor has the responsibility to plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement, whether caused by error or fraud. Because of the
nature of the audit evidence and the characteristics of fraud, the auditor is able to obtain reasonable, but not
absolute, assurance that material misstatements are detected. The auditor has no responsibility to plan and
perform the audit to obtain reasonable assurance that misstatements, whether caused by error of fraud, that
are not material to the financial statements are detected.
Material misstatement means a misstatement that affect a reasonable user's decision
Reasonable assurance, rather than absolute, is what is expected from the auditor as many reasons such as
sampling problem, concealment of evidences and auditor's mistakes affect the issuance of absolute assurance
Errors are unintentional misstatement while fraud is intentional. Fraud can be misappropriation of assets
(defalcation or employee fraud) or fraud lent financial reporting (management fraud).
Error may be mistakes in calculation; omissions misunderstanding of accounting standards, and incorrect
summarizations and descriptions. An example of misappropriation of assets (defalcation) may be taking the
physical cash; and fraud lent financial reporting may be an intentional over/understatement of books of
accounts.
Apart from errors and fraud, the auditor is also responsible to discover illegal acts (violation of laws and
regulation)

1.6.2 Legal Liabilities

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Legal liabilities are the professional’s obligation under the law to provide a reasonable level of care while
performing work for those he or she serves.
Audit professionals are liable to their clients for negligence, breach of contract, fail to perform services or not
exercise due care in their performance. Many accounting and legal professionals believe that a major cause
of lawsuits against CPA firms is lack of understanding by financial statement users of the difference between
a business failure and an audit failure and between an audit failure and audit risk. These three cases help in
answering the questions of legal liability.
A business failure – occurs when a business is unable to repay its lenders or meet the expectations of
its investors because of economic or business conditions, such as recession, poor management
decision, or unexpected competition in the industry.
Audit failure – occurs when the auditor issues an erroneous audit opinion as the result of an
underlying failure to comply with the requirements of generally accepted auditing standards (GAAS).
e.g. assigning unqualified assistants to perform audit tasks who then fail to find material
misstatements that qualified auditor would discover.
Audit risk – represents the risk that the auditor will conclude that the financial statements are fairly
stated and unqualified opinion can be issued when, in fact, they are materially misstated, even if
GAAS is applied.
Sources of legal Liabilities
There are four sources of auditor’s legal liability.
1. Liability to client under common law – these are the most common sources of lawsuits against
CPAs. They include:
 Failure to complete a non audit engagement on the agreed upon date
 Inappropriate withdrawal from audit
 Failure to discover defalcations (theft of assets)
 Breaching the confidentiality requirements of CPA
 Negligence performance etc…
2. Liability to the third party under common law – this arises when third part suffers a loss due to
reliance on misleading financial statements. The auditor is liable to the primarily stated beneficiary of
the audit opinion, to foreseen (auditors aware of users) etc… Third party includes vendors, actual &
potential investors, employees bankers & other creditors, customers etc…

3. Civil liability under the federal law – the auditor can be liable for breaching of federal security laws
and strict standards under the federal laws.
4. Criminal liability – if the auditor knowingly conceals material frauds, he/she faces trial against
criminal law.
Auditor’s Defenses against client’s suits
The CPA firm normally uses one or a combination of four defenses when there are legal claims by clients.
a- Lack of duty – means that the CPA firm claims that there was no implied or expressed contract.
e.g. for suits against uncovered misstatements, the CPA firm might claim that the firm did a review
service not an audit.
A common way for a CPA firm to demonstrate a lack of duty to perform is by use of an engagement
letter.
b- Non-negligent Performance – for non-negligent performance in an audit, the CPA firm claims that
the audit was performed in accordance with GAAS.
The Statements of Auditing Standards (SAS) make it clear that an audit in accordance with GAAS is
subject to limitation and cannot be relied on for complete assurance that misstatements will be found.

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c- Contributory Negligence – Exists when the client’s own action either resulted in the loss that is the
basis for damages or interfered with the conduct of the audit in such a way that prevented the auditor
from discovering the cause of the loss.
e.g. when false documents were given by the credit manager.
d- Absence of causal connection – an auditor’s legal defense under which the auditor contends that the
damages claimed by client were not brought about by any act of the auditor.
Auditor’s Defenses against third-party suits
Three of the four defenses available to auditors in suits by clients are also available in third-party lawsuits.
Contributory negligence is ordinarily not available because a third party is not in a position to contribute to
misstatement of financial statements. The preferred defense against third-party suits is non-negligence
performances.
1.7 Generally Accepted Auditing Standards (GAAS)
Setting auditing standards is one of the functions of AICPA (The American Institute of Certified Public
Accountants). Auditing standards are general guidelines to aid auditors in fulfilling their professional
responsibilities in the audit of historical financial statements. Besides setting up the standards the AICPA
has a function to conduct research and publications and continuing education.
There are 10 generally accepted auditing standards (GAAS), developed by AICPA in 1947; they have with
minimum changes remained the same. These standards are not sufficiently specific to provide any
meaningful guide to practitioners, but they do represent a framework upon with the AICPA can provide
interpretations.
Those 10 standards are categorized into 3 main categories as:
1. General Standards
2. Standards of field work
3. Reporting standards

I. General Standards – they stress on the important personal qualities that the auditor should posses. They are:
1. Adequate Technical Training & Proficiency – the auditor should have adequate technical training,
practical experience and formal education in auditing and accounting.
2. Independence in mental attitude – an auditor should be independent in all matters relating to the audit
assignment.
3. Due Professional Care – involves in carrying out auditing activities in full responsibility, diligently and
carefully. It includes consideration of the completeness of working paper, the sufficiency of the audit
evidence, appropriateness of audit report etc.
Generally due professional care is to be exercised in the planning and performance of the audit and the
preparation of the report. As a professional, the auditor must avoid negligence and bad faith, but the auditor
is not expected to make perfect judgments in every instances.
II. Standards of fieldwork – they concern on evidence accumulation and other activities during the actual
conduct of the audit.
4. Adequate planning & supervision – deals with ascertaining that the engagement (audit engagement) is
sufficiently planned to ensure an adequate audit and assistants (less experienced staff) are closely
supervised.
5. Understand the client’s internal control – if the internal control of the client is strong enough to give
adequate and accurate data, the audit evidence required may be less and vice versa. Understanding of the

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client’s internal control is helpful to plan the audit and determine the nature, timing, and extent of tests to
be performed.
6. Sufficient competent evidence - sufficient and competent evidential matter is to be obtained through
inspection, observation, inquiries and confirmations to afford a reasonable basis for an opinion reading
the financial statements. The auditor should exercise good judgment in deciding the amount and type of
evidence.
III. Standards of Reporting – the four reporting standards require the auditor to prepare a report on the
financial statements taken as a whole, including information disclosures. The requirement involves the
expression of statements preparation in light of GAAP, and the circumstances in which GAAP is not
consistently applied (yearly comparison).Thus the report shall:
7. State whether the financial statements are prepared in accordance with GAAPs.
8. Identify those circumstances in which such principles have not been consistently observed in the current
period in relation to the preceding periods.
9. Regard informative disclosures as adequate unless stated otherwise.
10. Either contains an expression of opinion regarding the financial statements, taken as a whole, or
assertions to the effect that an opinion cannot be expressed.

Statement of Auditing Standards (SAS) – are more specific guidelines issued by the Auditing Standards
Board of the AICPA..

1.8Audit Reports
Audit reports communicate auditor’s findings. Users of financial statements rely on the auditors report to
provide assurance on the company's financial statements. Report is the final stage in audit process.

Contents of standard auditor's report

Standard unqualified audit report. To enable users to understand audit report, professional standards
provide uniform wording for auditor's report. Standard unqualified reports have seven parts.

1. Report title: -
The title is required and includes the word independent.
2. Audit report address: -
The report may be addressed to stockholders, board of directors or the company. But addressing to
stockholders is becoming customary.

3. Introductory paragraph: -
The first paragraph of the report does three things: -

A. It makes a sample statement that CPA firm has conducted an audit to distinguish it from review or
compilation.
B. It state financial statements that were audited in the wordings given by management together with exact
dates or periods
C. It shows that the statements are the responsibilities of managers and the auditors work is to give an
opinion to indicate that the selection of GAAP is up to managers.
4. Scope paragraph: -

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It is a factual statement about what the auditor did in the audit. The statements in this paragraph should
consist: -
 Compliance of with GAAS
 The audit design to obtain reasonable assurance about the freedom from material misstatement
 Discuss audit evidence
 Included the word ‘test basis’ to indicate sampling.
5. Opinion Paragraph
The final paragraph includes conclusion. The opinion should be expressed as opinion rather than the absolute
facts (guarantee). This term "present fairly" is used to show the investigation is beyond GAAP.
6. Name of CPA Firm
Identifies the firm that conducts the audit.
7. Audit Report date
This is the end of significant audit procedure and marks the end of auditor’s responsibility.
Types of Audit Report
There are four types of Audit Report:
1. Unqualified Audit Report
2. Qualified
3. Adverse
4. Disclaimer

I. Unqualified audit Report

Unqualified Audit Report Can be Standard or with explanations:

A) Standard unqualified Audit Report

Conditions for standard unqualified opinion

1. All statements: - balance sheets, income statements, retained earnings and cash flow statements are
included in the financial statements

2. The three general standards have been followed in all respects.

3. The three standards of fieldwork are met and sufficient evidence has been accumulated.
4. GAAP is practiced with adequate disclosure.

5. There are no circumstances requiring the addition of an explanatory paragraph or modification of the
wording of the report.
Standard unqualified report is sometimes called clean report that needs no modification of auditor's opinion.
This is most common audit opinion.
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B)Unqualified Audit Report with explanatory paragraph /modified wording

This meets the criteria of complete audit with satisfactory results and financial statements that are fairly
presented, but the auditor believes it is important or is required to provide additional information. This
requires additional explanatory paragraph. The causes for the addition of explanatory paragraph are:-

Lack of consistent application of GAAP

In case of material change, explanatory paragraph is added after opinion paragraph to show the change.
The changes must affect consistency instead of comparability to be included in the fourth (explanatory)
paragraph.

Consistency refers to changes in: -

Accounting principles (LIFO to FIFO), in reporting entities, Correction of errors involving principles,

Whereas, comparability is: -

Change in all estimate variation in format (presentation of financial information) Changes due to different
transactions (events).
Substantial doubt about going concern
Recurring operating losses, deficiencies of working capital, inability to pay obligation, loss of major
customers and legal proceedings are major cause of this doubt. The reasonable period of continuation is 1
year from the date of financial statements.

Emphasis of Matter
While giving unqualified opinion, the auditor may add explanatory information for matters that he gave
emphasis such as significant and after balance sheet dates transactions etc.
Reports involving other auditors
In many companies having different branches may give the audit engagement to more than one CPA firm.
Each units (branches) audit results are compiled to form an over all report about the company as a whole.
The principal auditor, the one who does most of the audit, prepares this report in three different ways: -

A. No reference of the other auditor in the report

When the principal auditor knows or closely supervises the other auditor or the other auditor audited an
immaterial portion of the audit, the principal auditor doesn't refer the other auditor.

B. Make reference in the report (modified wording)

This report is called a Shared Opinion (Report). If the other auditor audits immaterial portion of the
statement and it is difficult to review his/her work, the principal auditor refers him/her in the introductory,
scope and opinion paragraphs.

C. Qualify the opinion

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If the principal auditor isn't willing to assume any responsibility for the work of the other opinion, he/she
may give a qualified or disclaimer opinion.
Reasons for departure from unqualified opinion
The auditor may issue a type of report other than unqualified opinion (qualified, disclaimer or adverse)
For the following reasons:-

Scope limitations: - If the auditor is restricted from obtaining sufficient evidence

GAAP departure: - If the client's practice departed from GAAP,
The auditor isn't independent: - this violated rule 101

II. Qualified opinion

This is when there is a limitation on the scope of the audit or when GAAP isn't followed, this opinion may
results. In fact the auditor must believe that the overall financial statements are fairly stated.
The qualification may be both the scope and the opinion or the opinion alone. The former arises only
when all evidences as required by GAAS aren't accumulated, while the later is issued when GAAP is
violated.

The unique feature of a qualified opinion is the inclusion of the term ' except for ' in opinion paragraph.

III. Adverse opinion

This is used only when the auditor believes that overall financial statements are so materially misstated or
misleading. This happens only when the auditor knows or believes, after adequate investigation, that lack
of conformity with GAAP. This opinion, however, is rare.

IV. Disclaimer Opinion

This is issued when the auditor has been unable to satisfy himself / herself that the overall financial
statements are fairly presented. Disclaimer happens when sever limitation on the scope and non-
independent relationship arises. It can be issued in case of going concern problem.
In the adverse opinion, the auditor must have the knowledge that financial statements are materially
misstated while in disclaimer he lacks such knowledge.
Materiality
If the misstatement is immaterial, unqualified opinion can be given. Other wise, adverse or disclaimer
opinion should be issued. Materiality is a misstatement of financial statements that would affect a decision of
reasonable uses of statements.

Levels of materiality
There are three levels:-
Immaterial amount
If the misstatement is immaterial, unqualified report could be issued.
Material amount that doesn't overshadow the financial statements.

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Here qualified opinion (using "except for") is issued. This affects decision only in specific areas and the
overall statements are presented fairly.

Material amount that affects the overall fairness of financial statements.

This affects users to make incorrect decisions. So, disclaimer or adverse opinion may be issued. In addition,
in the extent to which the misstatement affects different parts of financial statements must be considered.
This is called pervasiveness.
If misstatement is pervasive, adverse opinion is appropriate while lack of independence Bach to disclaim
opinion. Any deviation from independence is considered material.
Materiality can also be looked in terms of failure to follow GAAP or scope Limitations.

Illustrations of Types of Audit Repots.

ANDERSON and ZINDER, P.C
I.    Standard Unqualified Audit Report.
Certified
Public Accountants

A. Pure/clean VersionAuditor’s Report

Independent

To the Stockholders
General Ring Corporation

We have audited the accompanying balance sheet of General Ring Corporation

as of December 31, 1999 and 1988, and the related statements of income,
retained earnings, and cash flows for the years then ended. These financial
statements are the responsibility of the Company’s management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

We conduct our audits in accordance with generally accepted auditing

standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on test basis, evidence supporting
the amount and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statements
presentation. We believe that our audit provides a reasonable basis for our
opinion.

In our opinion, the financial statements referred to above present fairly, in all
material respects, the financial position of General Ring Corporation as of
December 31,1999 and 1998 and the results of its operations and its cash flows
for the years then ended in conformity with generally accepted accounting
principles.

ANDERSON AND ZINDER, P.C, CPAs

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B. Unqualified Audit Report With Explanatory Paragraph or Modified Wording.

1. Explanatory paragraph because of change in Accounting Principles.

Independent Auditor’s Report

(Same introductory, scope, and opinion paragraphs as the standard report)

Fourth Paragraph- Explanatory paragraph.

As discussed in Note 8 to the financial statements, the company

changed its method of computing
Depreciation in 19998.

1. Explanatory paragraph because of Substantial Doubt about Going

Concern

Independent Auditor’s Report

(Same introductory, scope, and opinion paragraphs as the standard report)
Fourth Paragraph- Explanatory paragraph.
The accompanying financial statements have been prepared assuming that X- Company
will continue
as a going concern. As discussed in Note 11 to the financial statements, X- Company
has suffered recurring
losses from operations and has a net capital deficiency that raise substantial doubt
about the company’s
ability to continue as a going concern. Management’s plans in regard to these matters
are described in
Note 11. The financial statements do not include any adjustment that might result from
the outcome of this
uncertainty.

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II. Qualified Audit Report Due to scope restriction..

Independent Auditor’s Report

(Same introductory paragraph as standard report)

Except as discussed in the following paragraph, we conduct our Scope

Paragraph
audits…(remainder is the same as the scope paragraph in the standard report)

We were unable to obtain audited financial statements supporting the

company’s investment in a foreign affiliate stated as $475,000, or its equity
earnings of that affiliate of $365,000, which is included in net income, as Third Paragraph - Added
described in Note x to the financial statements. Because of the nature of the
company’s records, we were unable to satisfy ourselves as to the carrying value
of the investment or the equity in its earnings by means of other auditing
procedures.

In our opinion, except for the effects of such adjustments if any, might have
been determined to be necessary had we been able to examine evidence
regarding the foreign investment and earnings, the financial statements referred
to above present fairly, in all material respects, the financial position of General
Opinion Paragraph
Ring Corporation as of December 31,1999 and the results of its operations and
its cash flows for the years then ended in conformity with generally accepted
accounting principles.

III. Adverse opinion Due to Non-GAAP.

Independent Auditor’s Report

(Same introductory and scope paragraphs as the standard report)
(Same Third paragraph as in qualified report)
Opinion Paragraph
In our opinion, because of the effects of the matters discussed in the
preceding paragraph, the financial statements referred to above do not
present fairly, in conformity with generally accepted accounting
principles, the financial statements of B-company as of December 31,
1999,or the results of its operations and its cash flows for the year then
ended.

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