UNIT 1: Overview of Auditing

1.1 Introduction
Without question, the independent audit function plays an important role in both business and
society. Numerous third parties, including investors, creditors, and regulators, depend on the
competence and professional integrity of independent auditors.

Economic decisions are typically based upon the information available to the decision maker. To
obtain the most benefit, users should have economic information that is both relevant and
reliable.
This need for relevant and reliable financial information creates a demand for accounting and
auditing service.

1.2 Definition and basic features 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 and independent person.

Auditing enable the auditor to express opinion whether the financial statements are prepared, in
all material respects, in accordance with an identified financial reporting framework. This
framework (criterion) might be generally accepted accounting principles (GAAP), or the national
standard of a particular country.

Financial statements include balance sheet, income statement, statement of cash flow, notes and
explanatory material that are identified as being part of financial statements.
The phrases used to express the auditor’s opinion are that the financial statements ‘give a trued
and fair view’ or ‘present fairly in all material respective’.

Note that the auditor does not certify the financial statements or guarantee that the financial
statements are correct, he reports that in his opinion they give a ‘true and fair view’, or present
fairly’ the financial position.

1.4 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.
1.5 Accounting Vs Auditing
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.

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.

1.6 Types of audits and auditors

A. Types of Audits
Audits are often viewed as falling into three major types:
(1) Audits of financial statements,
(2) Operational audits, and
(3) Compliance audits.

1. Audits of financial statements: - 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
The most known types of auditors are
1. Independent auditors/External Auditors,
2. Internal auditors,
3. Government auditors.

1. Independent (external auditors): - Independent auditors have no connection to the firm as an

owner or employee/manager. The basic task of independent auditor is to confirm to the
owners that the employees are correctly reporting on their financial position and
performance.

2. Internal auditor: - An internal auditor is paid salary as employee on the organization that is
being audits. He/she is responsible to appraise and investigation the performance of unit
and/or units within the organization and give recommendation to top management.

3. Government audit: - The government auditor is paid a salary by the government. He/she is
responsible to the legislature or executive.
 CHAPTER 2
AUDITING PROFESSION

Objectives
This chapter covers the basic codes of professional conduct, which the auditors need to bear in
mind in carrying out their duties. The main source of material for code of professional conduct
in this unit is the AICPA’s code of professional ethics.

This chapter also covers the duties and legal liabilities of auditors.

Broadly defined, the term ethics represents the moral principles or rules of conduct recognized
by an individual or group of individuals. Ethics apply when an individual has to make a decision
from various alternatives regarding moral principles.

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.

Independence
The AICPA code of professional conduct requires a member in public practice to be independent
in the performance of professional services as required by standards promulgated by bodies
designated by council.

The requirement is stated in terms of “standards promulgated by bodies designated by council”

to conveniently permit inclusion or exclusion of independence requirements for certain types of
services provided by CPA firms. For example, independence is required for audits of annual
financial statement but a CPA firm can do tax return and provide management services without
being independent. Independence in auditing means an unbiased viewpoint in the performance
of audit test, the evaluation of results, and the issuance of the audit report.
Independence has two distinct aspects. First, the public accountants must in fact be independent
toward any enterprise they audit. Second, the relationships of public accountants with audit
clients must be such that they will appear independent to third parties.

Independences in fact refer to the auditor’s ability to maintain unbiased and impartial mental
attitude or state of mind in all aspects of work. As such independence in fact is not subject to
objective measurement and therefore can be judged only by the auditor.

Independence in appearance refers to the auditor’s freedom from conflict of interest, which third
parties may infer from circumstantial evidence.

The following paragraphs illustrate some of the common situations, which may impair
independence:

Investment interest in audit client: - An auditor’s investment in shares, bonds, mortgage, and
notes of an audit client or its associates, either direct or indirect, may impair independence. In
this situation, an auditor may be in a position to issue an opinion or to influence the client’s
financial statements for personal financial gains at the expense of his/her capacity as auditor.
Such an investment is not limited to the auditor but also applies to his or her immediately family
and to partners and their immediate families.

Non audit functions and services: - Certain functions are incompatible with the auditing
function. These include functioning as a director, officers or employee of an audit client. The
auditor’s involvement in these functions and services creates a conflict of interest.

Litigation between CPA firm and client: When there is a lawsuit or intent to start a lawsuit
between a CPA firm and its client, the ability of the CPA firm and client to remain objective is
questionable.

Hospitality or goods and services: - This will affect independence unless it is modest.
Undue dependence on income: - If the amount of income from a client is very large as
compared to the total annual income of the audit firm, independence will be impaired since the
auditors want to maintain this financial interest.
Professional Requirements
A professional accountant should perform professional services with due care, competence and
diligence and has a continuing duty to maintain professional knowledge and skill at a level
required to ensure that a client or employer receives the advantage of competent professional
service based on up-to-date development in practice, legislation and techniques.

Auditing standards require auditors to have adequate educational requirement as well as other
moral and legal criteria fulfillment. The educational requirements are composed of theoretical
knowledge and practical experience.

Professional Ethics
All recognized professions have developed codes of professional ethics. Professional ethics refer
to the basic principles of right action for the member of a profession. Professional ethics may be
regarded as a mixture of moral and practical concepts. Thus the professional ethics of an
accountant would signify his behavior towards his fellows in the profession and other
professions and towards members of the public.

The fundamental purpose of such codes is to provide members with guidelines for maintaining a
professional attitude and conducting themselves in a manner that will enhance the professional
stature of their discipline.

The AICPA code of professional conduct considers the following to be followed by auditors
(accountants) in the conduct of professional relations with others.

Integrity: - An accountant should be straightforward, honest and sincere in his approach to

his professional work.
Objectivity: - An accountant should be fair and should not allow bias to override his objectivity.
When reporting on financial statements, which come his review, he should maintain an
impartial attitude.
Independence: - When in public practice, an accountant should both be and appear to be free
of any interest which might be regarded, whatever its actual effect, as being incompatible with
integrity and objectivity.

Confidentiality:
Confidentiality: - A professional accountant should respect the confidentiality of information
acquired in the course of his work and should not disclose any such information to a third party
without specific authority or unless there is a legal or professional duty to disclose.
Technical standards: - An accountant should carry out his professional work in accordance
with the technical and professional standards relevant to that work.

Professional competence: - An accountant has a duty to maintain his level of competence

throughout his professional career. He should only undertake works, which he or his firm can
expect to complete with professional competence.

Ethical behavior: - An accountant should conduct himself with a good reputation of the
profession and refrain from any conduct, which might bring discredit to the profession.

Contingent fess: - The AICPA code of professional conduct prohibits a CPA firm from
rendering any professional services on a contingent fee basis.

Responsibilities to colleagues: - The auditor should promote cooperation and good relations
with other members of the profession.

Advertising: - The advertising should not be false or misleading,” should not contravene
“professional good taste,” should not make “unfavorable reflection on the competence or
integrity of the profession,” and should not” involve a statement the contents of which” cannot
be substantiated.

Legal Responsibility and Liability Of Auditors

The auditor is responsible for his report. The auditor then has certain duties to fulfill to the users
of the financial statements that he reports on.

Responsibilities impose liabilities if things go wrong.

Liability
The CPA can be sued under the following legal concepts
a. Prudent man concept: - The auditor is responsible for exercising due professional care,
and he is subject to lawsuit if he fails to do so.
b. Liable for acts of others: - The partners are jointly liable for civil actions against a
 partner.
c. Lack of privileged communication: - CPAS do not have the right under common law to
withhold information from the courts on the grounds that the information is privileged.

Definition of Terms
Negligence:
Negligence: is violation of legal duty to exercise a degree of care that an ordinary prudent
person would exercise under similar circumstances with resultant damages to another party.

Gross negligence:
negligence: is lack of event slight care. Many jurisdictions consider gross negligence
equivalent to constructive fraud.

Fraud: is defined a misrepresentation by a person of a material fact, known by that person to be

untrue.

Constructive fraud:
fraud: differs from fraud as defined above in that constructive fraud does not
involve a misrepresentation with the intent to deceive.

Privity: is the relationship between parties to a contract.

Breach of contact:
contact: is failure of one or both parties to a contract to perform in accordance with
the contract’s provisions.

Proximate cause:
cause: exists when damage to another is directly attributable to a wrongdoer’s act.

Contributory negligence:
negligence: is negligence on the part of the client that has contributed to his or her
having incurred a loss.

A. Auditors’ liability to their clients

When CPAS take on any type of engagement, they are obliged to render due professional care.
This obligation exists whether or not it is specifically set forth in the written contract with the
client. Thus, CPAS are liable to their clients for any losses proximately caused by the CPA’ S
failure to exercise due professional care. That is to recover its losses, an injured client need only
prove that the auditors were guilty of negligence and that the auditors’ negligence was the
proximate cause of the client’s losses.
A. Auditors’ liability to third parties
Bankers and other creditors or investors who utilize financial statements covered by an audit
report can recover damages from the auditors if it can be shown that the auditors were guilty of
fraud or gross negligence in the performance of their professional duties.

Moreover, the auditors can be held liable for negligence to a limited class of third parties if the
auditors have actual knowledge of such third parties or if there exists a special relationship
between the auditors and the third parties.

The clients (plaintiffs) must prove that they sustained losses, that they relied on the audited
financial statements, which were misleading, that this reliance was the primate cause of their
losses, and that the auditors were negligent.

B. Auditors’ responsibility for the detection of fraud and error

The detection and prevention of error and fraud is the management’s responsibility by designing
and implementing appropriate internal control systems. The auditor is not responsible for the
prevention and detection of error and fraud. The auditor is responsible to design audit
procedures to reduce the risk of not detecting a material error or fraud, to an appropriate level to
provide reasonable assurance. Accordingly, the auditor must exercise due care in planning,
performing, and evaluating the results of audit procedures.
 CHAPTER 3
AUDITING TOOLS AND PRINCIPLES

Objectives
After studying this chapter, you will be able to know about
 the audit objectives
 principles of auditing
 auditing standards
The objectives of each audit must be clearly specified in order to ensure appropriate goal
achievement. Appropriate auditing principles and standards should be developed by auditors to
direct the objectives.

Audit planning is a vital area of the audit which is primarily conducted at the beginning of the
audit process. This chapter also considers the basic contents of audit working papers and audit
sampling.

Audit Objectives
The objective of the ordinary examination of financial statements by the auditor is expression of
an opinion on the fairness of the financial statements. It is customary in the audit to identify
audit objectives for the audit in general and for each account reported in the financial statements.
These objectives are derived from management’s assertions.

The auditor’s objectives are closely related to management assertions. Audit objectives are
intended to provide a framework to help the auditor accumulate sufficient and competent
evidence required by the third standard of fieldwork and decide the proper evidence to
accumulate given the circumstances of the engagement.

A distinction must be made between general audit objectives and specific audit objectives for
each account balance. The general audit objectives discussed here are applicable to every
account balance but stated in broad terms. Specific audit objectives are applied to each account
balance on the financial statement.
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).
1. 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.
2. Completeness: - there are no unrecorded assets or liabilities, transaction or events.
3. Occurrence: - a transaction or event occurred during the relevant accounting period (i.e.
has correct cut-off been applied?).
4. Measurement: - a transaction or event is recorded at the proper amount and in the
correct period.
5. Ownership: - an asset pertains (i.e. belongs) to the entity.
6. Valuation: - the asset or liability is recorded at an appropriate carrying value.
7. Presentation and disclosure: - must be in accordance with the relevant legislation and
accounting standards (i.e. the applicable financial reporting framework).

Auditing Principles
Auditing principles are generally, guidelines that help direct or chart goals and aims. Principles
are based on concepts or assumptions, and/or developed from particular observations. The
following are the basic principles:

a. Integrity, objectivity and independence.

independence. The auditor should be straightforward, honest,
and sincere in his approach to his professional work.
b. Confidentiality: - the audit should respect the confidentiality of information acquired in
the course of his work and should not disclose any such information to a third party
without specific authority unless there is legal or professional duty to disclose.
c. Skills and competence: - the audit should be performed and the reports prepared with
due professional care by persons who have adequate training, experience and competence
in auditing.
d. Documentation: - the auditor should document matters which are important in providing
evidence that the auditor was carried out with the basic principles.
 e. Planning: - the auditor should plan his work to enable him to conduct an effective audit
in efficient and timely manner.
f. Audit evidence: - the auditor should obtain sufficient appropriate audit evidence through
the performance of compliance and substantive procedures to enable him to draw
conclusion there from and give opinion on the financial statements.
g. Accounting system and internal control: The auditor should gain or understanding of
the accounting system and related internal controls to determine the nature, extent, and
timing of audit procedures.

Audit Standards
Standards are authoritative rules for measuring the quality of performance. The existence of
generally accepted auditing standards is evidence that auditors are very concerned with the
maintenance of a uniformly high quality of audit work by all independent public accountants.

The 10 GAAS are stated in their entirety as follows:

General standards
1. The examination is to be performed by a person or persons having adequate technical
training and proficiency as auditor.
2. In all matters relating to the assignment, independence in mental attitude is to be maintained
by the auditor or auditors
3. Due professional care is to be exercised in the performance of the examination and the
preparation of the report.

Standards of fieldwork
1. The work is to be adequately planned and assistants, if any, are to be properly supervised.
2. The auditor should obtain a sufficient understanding of the internal control structure to plan
the audit and to determine the nature, extent and timing of tests to be performed.
3. Sufficient competent evidential matter is to be obtained through inspection, observation,
inquiries, and confirmation to afford a reasonable basis for an opinion regarding the financial
statements under examination.
Standards of reporting
1. The report shall state whether the financial statements are presented in accordance with
 generally accepted accounting principles.
2. The report shall identify those circumstances in which such principles have not been
consistently observed in the current period in relation to the preceding period.
3. Informative disclosures in the financial statements are to be regarded as reasonably adequate
unless otherwise stated in the report.
4. The report shall either contain an expression of opinion regarding the financial statements,
taken as a whole, or an assertion to the effect than an opinion cannot be expressed.
Keep in mind, however, that these standards represent the minimum requirements for all audit
engagements.

Audit Planning and Audit Program

The first standard of fieldwork states:
“The work is to be adequately planned, and assistants, if any, are to be properly supervised.”
The concept of adequate planning includes investigating a prospective client before deciding
whether to accept the engagement, obtaining an understanding of the client’s business
operations, and developing an overall strategy to organize, coordinate, and schedule the activities
of the audit staff.
In planning the audit the auditor needs to consider the following:
1. the terms of the engagement and the expected date of the report.
2. the nature of the client’s business, include applicable statutory and contractual
requirements.
3. the experience gained during previous audit engagements.
4. the accounting policies and degree of complexity of the accounting system.
5. materiality and the components of audit risk.
6. any involvement of other auditor.
7. any involvement of internal auditors and persons having special expertise.
8. the intended reliance on internal control.
9. the level of experience and the number of audit staff for the engagement.
10. the timing and effectiveness of performing of the audit procedures.
a. Client acceptance
The auditors should investigate the history of the prospective client, including such matters as
the identities and reputations of the directors, officers, and major shareholders, its financial
statements and audit report.

Sources of information
1. Communication with predecessor auditors.
3 Make enquiries of other third parties (e.g. banker.).
4 Consult the client’s legal counsel.

b. Obtaining the engagement

After the auditors have collected the necessary information on the potential client, they will be in
a position to assess the various risk involved with the audit and determine whether to attempt to
obtain the engagement. Often they will be asked to submit a proposal which will include
information on the nature of services that the firm will offer, the qualification of the firm’s
personnel, and other information to convince the prospective client to select the firm.

Fee arrangement:
arrangement: when the business engages the services of independent public accountant, it
will usually ask for an estimate of the cost of the audit.

Engagement letter:
letter: The preliminary understandings with the client should be summarized by
the auditors in an engagement letter, making clear the nature of the engagement, any limitations
on the scope of the audit, work to be performed by the client’s staff, schedule dates for
performance and completion of examination, and the basis for computing the auditors’ fee.

c) Obtaining an understanding of the client’s business.

After the engagement is accepted, the auditors must obtain a detailed understanding of such
factors as the client’s financial position and operating results, organization structure, product
lines, and methods of production and distribution. This will help auditors to evaluate the
appropriateness of the accounting principles in use or the reasonableness of the many estimates
and assumptions embodied in the client’s financial statements.

d) Developing an overall audit strategy

After obtaining knowledge of the client’s business, the auditor should formulate an overall audit
strategy for the upcoming engagement. The best audit strategy is the approach that results in the
most efficient audit.
In planning an audit, the auditors must consider carefully the appropriate levels of materiality
and audit risk.

Materiality:
Materiality: In planning the audit, auditors should design their audit procedures to avoid
wasting time searching for immaterial misstatements that cannot affect their report.

Audit risk:
risk: The term audit risk refers to the possibility that the auditors may unknowingly fail to
appropriately modify their opinion on financial statements that are materially misstated.
In developing an audit plan, the auditors must consider factors that affect audit risk.

e) Audit plans
The planning process is documented in the audit working papers through the presentation of
audit plans,
plans, audit programs, and time budget.
budget. An audit plan is an overview of the engagement,
outlining the nature and characteristics of the client’s business operations and the overall audit
strategy. A typical audit plan includes the following:
1. description of the client’s company-its structure, nature of business, &
organization.
2. objectives of the audit.
3. nature and of extent of other services.
4. timing and scheduling of audit work.
5. work to be done by the client’s staff.
6. staffing requirement during the engagement.
7. target dates for completing major segments of the engagement.
8. preliminary judgment about materiality and risk levels for the engagement.

f) Designing audit programs

An audit program is a detailed list of audit procedures to be performed in the course of the
examination. An audit program is designed to accomplish certain objectives with respect to each
major account in the financial statements. These objectives follow directly from the assertions
that are contained in the client’s financial statements.

Audit Working Papers

Working papers are records kept by the auditor of the procedures applied, the test performed, the
information obtained, and the pertinent conclusions reached in the audit. For example, when
samples are takes for audit tests, the items drawn must be recorded and computations must be
made.

Working papers provide:

1 the principal support for the auditor’s report.
3 a means for coordinating and supervising the audit, and.
4 evidence that the audit was made in accordance with GAAS.
Working papers normally include the audit plan and programs, documentation of the auditor’s
understanding of the internal control structure, the assessed level of control risk, account
analyses explaining the composition of account balances, reconciliation of related records, letters
of confirmation and representation, recommended journal entries if necessary to correct the
accounts, and trial balances and other schedules that summarize the contents of other working
papers.

Audit Sampling
1. Definition: Application of audit procedures to less than 100 % of the items within an account
balance or class of transactions to obtain and evaluate audit evidence about some
characteristic of the items selected in order to form or assist in forming a conclusion
concerning the population.

Sampling risk
Because the auditor dose not examine all the items in the population when applying audit
sampling, there is a risk that the conclusion that he draws will be different from that which he
would have drawn had he examined the entire population. This is ‘sampling risk’.

The following are the basic factors affecting sample size:

1. population size.
2. standard deviation.
3. materiality.
4. reliability.

Statistical and non-statistical sampling

Statistical sampling involves the use of mathematical procedures, such as probability theory to
draw conclusions reached about the population. Non-statistical sampling techniques rely on the
auditors’ judgment to draw conclusions.

5. Constructing sampling
The steps involved in sampling can be summarized as follows:
i- Sample design:
design: - when designing an audit sample, the auditor should consider the
specific audit objectives, the population from which the auditor wishes to sample, and the
sample size
ii- Selection of the sample:
sample: - the auditor should select sample items in such a way that the
sample clan be expected to be representative of the population.
iii- Evaluation of the sample:
sample: - having carried out, on each sample item; those audit
procedures that are appropriate to the particular audit objective, the auditor should:
a) Analyze any errors detected in the sample.
b) Project the errors found in the sample to the population, and
c) Reassess the sampling risk.
After the general objectives are understood, specific objectives for each account balance on the
financial statements can be developed.
 CHAPTER 4
THE AUDITING PROCESS

Introduction
Audit evidence is a fundamental concept in auditing. Audit evidence consists of underlying
accounting data and all corroborative information available to the auditor.
Both categories of evidential matter are required in making an audit in accordance with GAAS.

The principal types of corroborating information areas follow:

Analytical evidence
Analytical evidence involves comparison of current period client data, such as total revenues or
return on assets, with expected values for the data based on
1) Historical or budgeted amounts for the client or
2) Industry data.

The reliability of analytical evidence is dependent on the relevance of the comparable data.

Documentary Evidence
Documentary evidence includes a wide variety source documents as well as such items as
minutes of board of director or executive committee meetings, lease agreements various other
contracts, and bank statements.
Confirmations
Confirmations constitute a special class of documentary evidence involving direct written
responses by knowledgeable third parties to specific requests for factual information.

Written representations
Written representations are signed statements by responsible and knowledgeable individuals that
bear on one or more of management’s assertions.

Mathematical evidence
Mathematical evidence results from recompilations by the auditor and comparison of those
results the client’s computations.
Oral evidence
During the audit, an auditor receives oral responses to numerous inquiries directed to officers
and employees of the client and others.

Physical evidence
Physical evidence is obtained from the physical examination or inspection of tangible assets.

Documents and Record Examination

In the early stages of an audit, the external auditors must become familiar with many aspects of
the client’s business. For example, the auditors must obtain knowledge of the client’s
organization plan, financial structure, physical facilities, products, accounting policies, and the
control procedures. However, information about the internal activities of the client is not in itself
sufficient.

If this information is to be interpreted and evaluated in a proper perspective, the auditor must
also understand the business environment in which the client operates. The auditors can gain
considerable information about both the client’s business environment and internal operations by
examining the client’s general records. The term general records is used to include the following
categories:

1. Non-financial records
 Articles and certificates of corporations and bylaws
 Partnership contract
 Minutes of directors and shareholders meetings
 Contracts with customers and suppliers
 Contracts with officers and employees
 Government regulations directly affecting the enterprise
 Correspondence files

2. Financial records
 Income tax returns of prior years.
 financial statements and annual reports of prior years.
3. Accounting records
 General
General ledger.
General
General journal.

Audit Evidence
During financial statement audits, the auditors gather and evaluate evidence to form an opinion
on whether financial statements follow the appropriate criteria, usually GAAP.

Gathering sufficient appropriate audit evidence is the very essence of auditing. The third
standard of fieldwork states:

Sufficient appropriate evidence should be obtained by such means as inspection, observation,

enquiry, confirmation, computation and analysis, to afford a reasonable basis to support the
content of the report.

a. Sufficient, Appropriate Evidence

The auditor’s judgment as to what constitutes sufficient appropriate evidence is influenced by
such factors as:
a. Materiality of the item.
b. Inherent risk and control risk considerations.
c. The experience gained during previous audit examination as to the reliability of the
client’s records and representation.
d. The persuasions of the evidence.
e. Fraud or error while performing as audit procedures.

b. Procedures to Obtain Evidence

Audit evidence is any information that corroborates or refutes an assertion. Here we will briefly
recap a number of audit procedures.

Physical examination:
examination: - means to review physical evidence of an asset. For example, the
auditors might physically examine plant equipment or inventory items to obtain evidence as to
their existence or condition.

Confirmation:
Confirmation: - is the process of obtaining evidence by written, direct communication with the
debtor, creditor, or other party of the transaction.
Tracing:
Tracing: - is the proof establishing the completeness of transaction processing by following a
transaction forward through the accounting records.

Vouching: - is the process of establishing other accuracy of recorded transactions by following a

transaction back to supporting documents from a prior processing step.

Re-performance:
Re-performance: - is the process of repeating a client activity.

Observation:
Observation: - is the process of viewing a client activity. For example, the auditors may
observe the application of internal control procedures.

Inspection: - involves a reading or point – by – point review of a document or second. For

example, the auditors may inspect a loan agreement.
Reconciliation:
Reconciliation: - are used to establish agreement between two sets of independently maintained
but related records.

Enquiries: - are questions directed toward appropriate client reasoned. The responses to the
question may be oral or in written.

Analytical procedures:
procedures: - are evaluations of financial information made by a study of expected
relationships among financial and non-financial data.

c. Sufficiency of Evidence
The term sufficient relates to the quantity of evidence the auditors should obtain. The amount of
evidence that is considered sufficient to support the auditor’s opinion is a matter of professional
judgment. However, the following considerations may be useful in evaluating the sufficiency of
audit evidence.
1. The amount of evidence that is sufficient in a specific situation varies inversely with the
appropriateness of evidence available. Thus, the more appropriate the evidence, the less
the amount of evidence that is needed to support the auditors’ opinion.
2. The need for audit evidence is closely related to the concept of materiality. The more
material a financial statement amount, the greater the need for more evidence as to its
validity.
3. As the relative risk associated with a particular engagement increases, the auditors should
require more evidence to support their opinion.
d. Appropriateness of Audit Evidence
The appropriateness of audit evidence refers to its quality or reliability. To be appropriate,
evidence must be both valid and relevant.
The competency (or reliability) of accounting records is directly related to the effectiveness of
the client’s internal controls. Strong internal controls enhance the accuracy and reliability of the
financial records.
The competency of corroborative information depends on many factors. The considerations that
have the widest applicability in audit are:
- relevance
- source
- timeliness
- objectivity
Several factors contribute to the quality of evidence, including the following:
1. When auditors obtain evidence from independent sources outside of the client company, the
reliability of the evidence is increased.
2. Strong internal control contributes substantially to the quality of accounting records and other
evidence created within the client organization.
3. The quality of evidence is enhanced when the auditors obtain information directly, - that is,
by first hand observation, correspondence, or computation, rather than by obtaining the
information second hand.

Working Papers
Working papers are vitally important tools of the auditing profession.
Working papers are the connecting link between the client's accounting records and the auditors
report. They document all of the work performed by the auditors and provide the justification
for the auditors’ report.

The documentation of audit evidence is provided in working papers. Working papers provide
- The principal support for the auditor’s report.
- A means for coordinating and supervising the audit.
- Evidence that the audit was made in accordance with GAAS.
a. Functions of working Papers
Audit working papers assist auditors in several major ways: they
Provide a means of assigning and coordinating audit work;
b) Aid seniors, managers, and partners in supervising and reviewing the work of assistants;
c) Provide the support for the auditors’ report;
d) Document the auditors’ compliance with GAAS; and
e) Aid in planning and conducting future audits of the client.

b. Confidential Nature of Working Papers

Much of the information gained in confidence by the auditors is recorded in their working
papers; consequently, the working papers are confidential in nature.
Since audit working papers are highly confidential, they must be safeguarded at all times.
c. Organization of the Working Papers
The auditors usually maintain two files of working papers for each client:
1) current files for every completed examination and
2) a permanent file of relatively unchanging data.

d. Contents of Working Papers

Working papers would normally include the following matters:
 information concerning the legal and organizational structure of the entity.
 copies of important legal documents, agreements and minutes.
 information concerning the industry, and economic environment.
 evidence of the planning process.
 evidence of the auditors’ understanding of the accounting and internal control systems.
 evidence of inherent and control risk assessments.
 analysis of transactions and balances.
 analysis of significant ratios and trends.
 details of procedures regarding components whose financial statements are audited by
other auditors.
 copies of communications with other auditors, experts, and other third parties.
 letters of representation by the client’s management.
 copies of the approved financial statements and auditors’ reports.
Unit 5: Internal Control

5.1 Introduction
The Important consideration of internal control in this unit has three major objectives first, to
explain the meaning of internal control, second, the significance of purpose and objective of
internal control third, the characteristics of good internal control. In this Unit, students should
able to know the broad classification of internal control as accounting and administrative control;
and the major weakness of internal control. This unit tries to show the internal control over cash,
Accounts Receivable (credit sales), payroll, and fixed assets.

5.2 Definition
Internal Control is a process effected by an entity’s board of directors, management, and other
personnel that is designed to provide reasonable assurance regarding the achievement of
objectives in the following categories.

(1) effectiveness and efficiency of operations

(2) Reliability of financial reporting, and
(3) Compliance with applicable laws and regulations. alternative definition defined by
AICPA (American Institutes for certifications of public accountants) as: Internal control
referees to all coordinate methods and measures within an organization or within a
system adopted to safeguard assets, cheek accuracy and reliability of accounting data,
promote operational efficiency and encourage adherence to prescribed managerial policy.

Overall internal controls are also defined as operational checks and balances that prevent loss
due to fraud, waste, abuse, and management of resources. The resources include: personnel,
information, and capital.

5.3 Purposes and objectives of internal control

The purpose of internal control can be explained in to two aspects:

a) The management (client) concern and
b) The Auditors concern
(a) The client concern – the reason an organization establishes a system of internal control is to
attain objectives (goals). Generally management has six purposes in setting good system of
internal control. These are to:
(i) achieve reliability of accounting records.
(ii) safeguard assets
(iii) increase profitability
(iv) prevent and defeat frauds and errors
(v) prepare financial statements timely
(vi) discharge laws, rules & regulations
(b) Auditors concern:
concern: The generally accepted auditing standard field work standard,
number, (3) three states that a sufficient understanding of internal control is to be
obtained to plan the audit and determine the nature, timing and extent of testes to be
performed. Thus, the primary purpose of studying and evaluating of internal control
system by external auditors is to determine the amount of audit work. It is assumed that
good internal control provides more reliable financial data and statements.

The objectives internal control includes to:

(i) control operations – to ensure efficiency and effectiveness
(ii) control financial reports – To ensure the preparation of reliable financial
statements
(iii) control compliance – To ensure compliance of laws, regulations.

5.4 Essential elements of sound (effective) Internal control

Essential elements are components of strong internal control. They are used to evaluate the
strengths and weakness of internal control system.

5.4.1. Competent, trustworthy personnel with clear lines of authority and

responsibility
The most important element of any internal control is personnel. If the employees are
component (well trained) and trustworthy (TRUST), some of other elements can be absent and
reliable financial information’s will still result. Specific responsibility for performance of a
given duties must be assigned to specific Individuals. Organizational structure defines how
authority and responsibility are delegated and monitored. It provides a frame work for planning
executing, and monitoring operations.

5.4.2 Segregation of Duties

It is Important for an organization to segregate (separate) the authorization of transactions,
recording of transactions, and custody of the related assets. Independent performance of each of
these functions reduces the opportunity for any one person to be in apposition both to perpetrate
and to conceal errors or Irregular in the normal course of his or her duties. Example: first, if an
employee can authorize the sale of marketable securities and has access to the stock certificates,
the assets can be misappropriated. Second, If an employee receive payment from customers on
account and has access to the accounts receivable subsidiary ledger, It is possible for that
employee to misappropriate the cash and cover the shortage in the accounting records.

There are four guidelines for segregations of duties to prevent both intentional and unintentional
errors and frauds.

(a) Separation of the custody of assets from accounting. For example, If one person is
responsible for store keeping (custody of inventory) and maintains inventory records,
it is possible to ship (dispatch) some Items for his /herself and adjust the Inventory
balance by recording a factious transaction.
(b) Separation of the authorization of transaction from the custody of related assets – for
example, If one person is assigned For authorization of payment transaction, and
handling of cash it in creases the possibility of frauds.
(c) Separation of duties within the accounting section function: Examples include: The
recording in journals and related subsidiary ledgers and then keeping of control
ledgers in principle should be separated. Recording in sales journals and recording in
cash receipts journal and Accounts Receivable control Ledger keeping should be
separated. Accounts payable control clerk should not record cash payments journal.
(d) Separations of operational responsibilities from record – keeping. For example,
accounting functions should be separated from management department activities.
5.4.3. Documentation Procedures
Documents provide evidence that transactions and events have occurred. Several procedures
should be established for documents. first, whenever, possible, document should be pre –
numbered and all documents should be accounted for pre numbering accounting documents
should be promptly forwarded to accounting to help timely recording documents should be
produced in copies, they should be simple to understand, sufficient, and designed for multiple
uses.

5.4.3. Authorization Procedures

Every transaction must be properly authorized. Properly authorization implies that concerned
personnel should authorize (approve) each transactions at each step where transactions occurs.
For example, the authorized person for paying cash is the cashier, for receiving, it is the store
clerk, for permitting the transaction it is the manager etc.

5.4.4. Physical Control Over Assets and Records

Physical control relates primarily to safeguard asset from theft, deterioration, spoilage, etc.
Accounting records and securities, (bonds, Debentures, Treasury stocks, cheeks, notes,) should
be in well locked custody. Inventories should be protected by constructing from fire proof
materials, well – ventilated room and locked doors, generally,
 Safes and vaults are necessary to store cash before the cash is deposited in a bank.
 Locked ware houses for inventories.
 Fencing of the organization.
 Locked storage cabinets for accounting records. etc; are necessary elements, of physical
control.

5.4.5. Internal verification (Independent Internal Verification or Checking)

This element of internal control refers to the need of Independent checking process. Which
involves, Reviewing, comparison, reconciliation of data, which are prepared by the other
personnel, and the findings (discrepancies) should be corrected.
5.5 Limitations of Internal control
An internal control system should be designed and operated to provide reasonable assurance.
That is an entity’s cost of internal control system should not exceed the benefits that are expected
to be derived. The necessity of balancing the lost of Internal controls with the related benefits
requires considerable estimation and judgment on the part of management.
Therefore the idea of reasonable assurance arises from two concepts: cost – benefit, and the
inherent weakness: The cost – includes paying employees for implementing the system,
constructing and acquiring facilities (safes, stoves) printing of vouchers, forms, etc. the benefits
includes prevention of potential losses.

The inherent limitations include management override of internal control, personnel errors, or
mistakes, and collusion.

(i) Management override of internal control: an entity’s controls may be overridden

by management. For example, a senior – Level manager can require a low – level
employee to record entries into the accounting records (because) that are not
consistent with the substance of the transactions and are in violation of the
organization’s control. The lower – level employee may record the transaction, even
though he or she knows that it is a violation of control, because of fear of losing he’s
or her job.
(ii) Personnel errors or mistakes – The internal control system is only as effective as
the personnel who implement and perform the controls. For example, employees may
misunderstand instructions or make errors of judgment. They may make mistakes
because of personnel careless ness, distraction, or fatigued.
(iii) Collusion – the effectiveness of segregation of duties lies in the Individuals per
forming only their assigned tasks or in the performance of one person being checked
by another. Collusion may occur, for example, an individual who receives cash
receipts from customers colide (agree) with the one who records those receipts in the
customers’ records order to steal cash from the entity.
 CHAPTER 6
AUDITORS’ REPORTS

Introduction
In order to convey information in a succinct form the audit report has become an extremely
formalized group of phrases, each of which has special significance.

Statutory Requirements

International Auditing Standards require the auditors to state explicitly whether in the auditors'
opinion the annual accounts have been properly prepared in accordance with the IFRS/GAAP
and in particular whether a true and fair view is given.
 In the balance sheet, of the state of the company's affairs at the end of financial year.
 In the profit and loss account, of the company's profit or loss for the financial year; and
 In the case of group accounts, of the state of affairs at the end of financial year and the
profit or loss for the year of undertakings including in the consolidation, so far as
concerns member of the company.
In addition, certain requirements are reported on by exception; the auditor only has to report if
they have not been met. The following are matters with which the auditors imply satisfaction in
an unqualified report.
 Proper accounting records have been kept and proper returns adequate for the audit
received from branches not visited.
 The accounts are in agreement with accounting records and returns.
 All information and explanations have been received as the auditors think necessary and
they have had access at all times to the company's book, accounts and vouchers.
 Details and directors' emoluments and other benefits, and particular of higher paid
employees have been correctly disclosed in the financial statements.
 Particulars of loans and other transactions in favor of directors and others have been
correctly disclosed in the financial statements.
  The information given in the directors' report is consistent with the accounts.

Directors' Emoluments

The auditor should include in their report the required disclosure particulars of directors'
emoluments and transactions with directors, if these requirements have not been complied with
in the accounts. This means that the auditors carryout various procedures to ensure that they are
aware of all such emoluments and transactions by reference to directors' service contracts, board
minutes, cash book payments and so on. Benefits received in kind may be particularly hard to
identify.

Qualifications in Audit Reports

Prior to the introduction of auditing standards, qualified audit reports were often criticized as
failing to convey the meaning intended.
The standard on audit reports aimed to:
a) outlaw the use of ambiguous ways of qualifying
b) categorize the circumstances giving rise to qualification
c) prescribe suggested wording and format for different categories of qualification
d) introduce a distinction between material and fundamental problems
e) promote better drafting by using non-technical language and clear presentation.

The Qualification 'Matrix'

Auditing standards give the circumstances in which each sort to qualification would be
appropriate where the auditors are unable to report affirmatively on the matters contained in the
paragraphs about which they are reservations, they should give:
a) a full explanation of the reasons for they qualification
b) whenever possible, a quantification of its effect on the financial statements. Where
appropriate, reference should be made to non-compliance with relevant legislation and
other requirements.
The standard stresses the fact that a qualified audit report should leave the reader in no doubt as
to its meaning and its implication for an understanding of the financial statements. In order to
promote a more consistent understanding of qualified audit reports, Accounting Practices Board
(APB) recommends that the forms of qualification described in the standard should be used
unless, in the auditors' opinion, to do so would fail to convey clearly the intended meaning.

The APB takes the view that the nature of the circumstances giving rise to a qualification of the
auditor's opinion will generally fall into one of two categories.
a) where there is a limitation in the scope of work which prevents the auditors from forming
an opinion on a matter (uncertainty).
b) where the auditors are able to form an opinion on a matter but this conflicts with the view
given by the financial statements (disagreement).
Case, uncertainty or disagreement, may give rise to alternative forms of qualification. This is
because the uncertainty or disagreement can be:
a) material but not fundamental; or
b) of fundamental importance to the overall true and fair view.
The standard requires that the following forms of qualification should be used in the different
circumstances outlined below.
Qualification Matrix
Nature of circumstances Material but not fundamental Fundamental
Limitation in scope Except for … might Disclaimer Adverse
disagreement Except for …

- Except for …might: Auditors disclaim an opinion on a particular aspect of the accounts,
which is not considered fundamental.
- Disclaimer of opinion: Auditors state they are unable to form an opinion on truth and
fairness.
- Except for: Auditors express an adverse opinion on a particular aspect of the accounts,
which is not considered fundamental.
- Adverse opinion: Auditors state the accounts do not give a true and fair view.

Pre-Audit Preparation
 Define the Purpose of the audit.
 Define the Objectives of the audit.
 Define the Scope of the audit.
Conduct a brief and informal question and answer session with department supervisor to
determine if there have been any material changes in operations since the last audit. If there has
been a material change, prepare a new Procedural Narrative for the permanent file.
If the scope of the audit is unusually large, or if the anticipated man-hours allotted for this audit
is projected to take longer than 10 business days, an Information and Documentation Request
form will be sent to the department manager giving them two weeks to gather all documentation
necessary to perform the audit.
 Establishing the Scope of the Audit
 Determine if this is an existent audit work program. If yes, go to #2.
If no, go to #3.
 Review work program and determine if there have been any material changes that would
warrant revising the work program:
 Have there been any changes in internal procedures?
 Has personnel been reduced in the area which could compromise dual controls?
 Have there been any regulatory updates that warrant review?
 Have any processes become automated?
 Create a work program for function to be audited.
 Review any published regulation or law and address all requirements.
 Incorporate internal processing procedures
 System Input/Output
 Written policies/procedures
 Secondary reviews/authorizations
 Develop an Internal Control Questionnaire if appropriate
 Substantially all questions should be answered with a YES/NO/NA

Conducting the Audit

Determine if Positive or Negative confirmations are applicable to the audit work conducted.
Prepare confirmations for delivery.
Determine the sampling method to be used for the audit. (See appendix for definitions of various
sampling methods).
Determine the type of reports needed to conduct the audit. Those typically best suited for audits
are: independent trial balances, summaries, exception listings, confirmation listings, analytical
reports, management reports, and internal audit administrative reports.
Preparing Work Papers
The work papers should tell a complete story of the work performed. It is imperative that the
record left by the auditor of the work that was performed and the conclusions reached is clear
and defensible. The following represents the way work papers should be created:
The work papers must document the scope of the work performed. This will include the audit
program, the percentage of items in the population that were tested, statistical sampling
techniques used, the inquiries made, the confirmations mailed and received, etc. The work
papers must clearly support the amount of testing that was undertaken was sufficient under the
circumstances.

The results of the audit test should be clear. This will include all of the audit exception items and
their resolution, the documents and document attributes examined, the reconciliations performed,
etc. This documents that all of the procedures in the audit program were indeed performed.

It should be made clear the link between any conclusion derived and the evidence obtained. All
of the judgments and interpretations made during the course of an audit should be in the work
papers and should be solidly based on the evidence gathered.
Tick marks should always be used consistently throughout the entire audit. No tick mark should
have more than one meaning at any time.

Preparing the Audit Report

Prepare an Excel spreadsheet of all audit findings. Fields should include: Work paper reference
Number, Section, ON/OFF report indicator, and a Comments Section. The Comments Section is
where the actual audit finding will be described.

Draft a Preliminary Report of all audit findings and audit recommendations. This report should
be discussed with the Department Manager and corrective actions should be addressed at this
time. The benefit of preparing a Preliminary Report is to allow the Department Manager to
defend itself against any findings. There may be a reasonable explanation for any finding.
However, additional documentation should be obtained before removing any exception from the
Final Audit Report. This provides an evidentiary trail to back up the Department Manager’s
position. Any exception to this requirement should be brought to the attention of the Internal
Auditor before the Final Audit Report is written. All Preliminary Reports should be indicated as
such by stamping “Tentative and Preliminary, Not for Distribution” to all pages of the report.
This will also be indicated on the audit findings report in the “Status of Finding” field.

The Final Audit Report should be prepared in accordance with the sample format attached. It
will be the policy of this department to obtain uniformity when writing all audit reports.
Each audit report should include:

 the purpose of the audit

 the objective of the audit
 the scope of the audit
 the sampling technique involved
 time frame in which the audit was conducted
 Description of audit procedures applied to test work
Assign a “PRIORITY” rating – LOW/MODERATE/HIGH – This directly correlates to the
associated risk.
State the “Status of Finding” – PRELIMINARY or FINAL.
Audit exception with the associated risk

Audit Recommendation
Corrective action taken. This is indicated in the audit report as the “Action Plan”.
Any Corrective Action taken must be completed prior to writing the Final Audit Report. This
demonstrates an agreement to each finding and facilitates corrective action. The Internal Auditor
must approve any exception.

Audit reports should be written in the active language, be impersonal, and be written in a positive
fashion. The Final Audit Report must express an opinion of the adequacy, effectiveness, and
efficiency of the control system and the quality of ongoing operations. When making a
recommendation for a corrective action in the report, a comment must be made on the potential
exposures that exist if the corrective action is not taken. For example, certain regulatory
violations could lead to Civil Money Penalties (CMPs) not only for the bank, but also for
individual employees.
For audits with an unusually high number of findings or for findings that are deemed to be in a
high-risk area, a time should be stated for an audit follow-up to ensure corrective actions have
been fully implemented.
For convenient reference, the auditors’ standard (unqualified) report is presented below.

Auditors’ Report to the Shareholders Of XYZ

We have audited the accompanying balance sheet of ABC Company as of December 31, 19 x 1,
and the related statements of income, retained earnings, and cash flows for the year then ended.
There financial statements are the responsibility of the company’s management. Our
responsibility is to express an opinion on those financial statements based on our audit.

We conducted an audit in accordance with generally accepted auditing standards. Those

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

In our opinion, the financial statements give a true and fair view of (or present fairly in all
material respects) the financial position of the company as of December 31, 19 x 1 and the
results of its operations and its cash flows for the year then ended in accordance with GAAP.
ABC Auditors

Date
Address
This report contains the following important elements:
- Title: Auditing standards require that the report be titled and include the word independent.
- Address: The audit report is addressed to the individual or group that engaged the auditors.
- Introductory paragraph: - The first paragraph of the report does three things:
 Specifies the financial statements to which the report relates,
 Specifies the respective responsibilities of directors and auditors, and;
  It makes the simple statement that the auditor has done an audit.

- Scope paragraph: -The

-The scope paragraph describes the nature of an audit. The scope
paragraph states the following the:
 auditors followed GAAS,
 audit is designed to obtain a reasonable assurance about whether the financial
statements are free of material misstatements.
 audit evidence accumulated and the auditor believes the evidence accumulated was
appropriate for the circumstances to express the opinion presented.
- Opinion paragraph: The final paragraph in the standard report states the auditors’
conclusion based on the results the audit examination.
- Name of the audit firm.
- Audit report date.
date. The appropriate data for the audit report is the one on which the auditor
has completed the most important auditing procedures in the field.

Expression Of An Opinion
The auditors’ opinions when expressing an opinion on financial statements may be summarized
as follows:
1. an unqualified opinion – standard report.
2. a qualified opinion.
3. an adverse opinion.
4. a denial opinion.
All significant reasons for the issuance of a qualified, adverse, or denial of opinion should be set
forth in a reservation paragraph between the scope and opinion paragraph.

Auditors must qualify their report whenever there are material deficiencies in the client’s
financial statements.

The Unqualified Report

The unqualified report is used when the following conditions are met:
1. All statements - balance sheet, income statement, statements of retained earnings, and
 statement of cash flows are included in the financial statement.
2. The three general standards have been followed in all respects on the engagements.
3. Sufficient evidence has been accumulated.
4. The financial statements are presented in accordance with generally accepted accounting
principles.
5. There are no circumstances requiring the addition of an explanatory paragraph or
modification of the wording of the report.

In general, auditors express an unqualified opinion on the client’s financial statements when
there has been no material departure from GAAP and there have been no material unresolved
restrictions on the scope of their audit.

Under certain circumstances, however, auditors may add additional wording to the standard
report even though they are issuing an unqualified opinion. This additional wording draws
attention to certain statutory requirements or a specific matter. Another modification of a
standard audit report is the auditors’ emphasis of a matter regarding the client’s financial
statements. Emphasis of matter may require in the auditor’s unqualified report 1) to highlight a
matter regarding a going concern problem and 2) when there is a significant uncertainty (other
than going concern problem), the resolution of which is dependent upon future events and which
may affect the financial statements.

Qualified Opinions
Auditors may issue opinions other than unqualified opinion when 1) they do not agree with the
accounting principles used in preparing financial statements or when they believe disclosures in
the statement are inadequate; 2) a change in accounting principle is not applied properly a as per
GAAP, and is not adequately disclosed in the financial statements; 3) there are limitations on
scope of examination; and /or 4) there is major uncertainty affecting a client’s business’.

A. Qualified opinion -except for:

for: This is issued when there is a limitation of Scope; or the
auditor disagrees with an accounting treatment or disclosure. The opinion states that
except for the effects of some material departure from GAAP, or some material limitation
in the scope of the auditors’ examination, the financial statements are presented fairly.
 The auditors’ reports should have a separate reservation paragraph disclosing the reasons
for the qualification.
B. Adverse opinion: This is a stronger form of ‘except for’ opinion – the disagreement is so
material that the financial statements as a whole are misreading. When the auditors
express an adverse opinion, they must have accumulated sufficient appropriate evidence
to support their unfavourable opinion.

Whenever the auditors issue an adverse opinion, they should disclose in a separate paragraph of
their report the reasons for the adverse opinion and the principal effects of the adverse opinion on
the client company’s financial position and operating results.

Example, an audit report that included an adverse opinion might have an opinion paragraph such
as the one as follows:

In our opinion, because of the effects of the matters discussed in the preceding paragraph, these
financial statements do not present fairly the financial positions of the company as at December
31, 19 x 1, and the results of its operations and cash flow position for the year then ended, in
accordance with generally accepted accounting principles.

C. Denial of opinion. A denial (disclaimer) of opinion is no opinion. In an audit

engagement, a denial is required when very significant restrictions on the scope of the
audit preclude compliance with generally accepted auditing standards.
A very significant scope limitation may be caused by the client or by the timing of the
auditors’ appointment and their audit work or by factors beyond the control of the client
or the auditors, rather than by restrictions imposed by the client.