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Auditing and Ethics
Chapter - 1

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 Concept Notes

Chapter -1

NATURE, OBJECTIVE AND SCOPE OF AUDIT

INTRODUCTION

Auditing is a critical process in the modern business environment that provides confidence
and assurance to a wide range of users, including investors, shareholders, banks,
governments, trade unions, and insurance companies, by examining and verifying financial
statements. Its nature and scope involve the examination of financial records, internal
controls, and compliance with laws and regulations. Auditing has limitations, and it does not
involve making financial decisions or providing absolute guarantees of financial success.

ORIGIN OF AUDITING

Auditing has a long history, with references found in ancient texts like Kautilya's Arthshastra
from the 4th century BC. The term "audit" comes from the Latin word "audire," meaning "to
hear," reflecting the early practice of auditors listening to accounts being read. In modern
history, the first Auditor General of India was appointed in 1860, and the Institute of
Chartered Accountants of India was established as a statutory body in 1949 to regulate the
profession of Chartered Accountancy in the country.

MEANING AND NATURE OF AUDITING

Auditing is a process where an independent expert reviews the financial information of any
organization, whether it's a for-profit business or not, regardless of its size or legal structure.

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The purpose of this examination is to provide an expert opinion on the accuracy and reliability
of that financial information.

An incisive analysis of above meaning of auditing brings out following points clearly:

A. Independence is Crucial: Auditing means checking financial information, and the auditor
must be independent. This means their judgment isn't influenced by anyone related to the
entity being audited. For example, if your brother is a Chartered Accountant, he can't audit
your business because his family ties might affect his judgment.
B. Applies to All Types of Entities: Auditing isn't just for profit-focused businesses. It can also
be done for non-profit organizations like NGOs or charities. Plus, it's not limited by the size or
legal structure of the organization. It can be done for small businesses, big corporations,
partnerships, limited liability partnerships (LLPs), private companies, public companies,
societies, and trusts.
C. The Goal is to Give an Expert Opinion: Auditing's main purpose is to provide an expert's
opinion on financial statements. This opinion ensures that the financial information in those
statements is accurate and reliable. It's like having a referee in a game to make sure the rules
are followed.

He has to see that financial statements would not mislead anybody by ensuring that: -
• Accuracy: Auditors make sure that the financial statements match the company's actual
records.

• Evidence Backing: They check that all the numbers have proper proof and documentation.

• No Missed Entries: Auditors ensure that nothing important is left out when creating the
financial statements.

 Clarity: They confirm that the financial information is clear and easy to understand, not
confusing.

• Follow the Rules: Financial amounts are categorized, described, and disclosed as per
accounting standards

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• True and Fair Picture: Auditors guarantee that the financial statements show a real and
honest view of the company's financial health.

INTERDISCIPLINARY NATURE OF AUDITING RELATIONSHIP WITH DIVERSE SUBJECTS

Auditing is a multidisciplinary field that incorporates principles from accounting, law,

behavioral science, statistics, economics, and financial management. Auditors require a solid
understanding of accounting principles for financial statement examination and compliance
assessment with business and taxation laws. Interaction skills, statistical methods, economic
comprehension, financial management knowledge, and awareness of financial markets are
crucial elements in performing comprehensive audits.

Data
Processing

Behavioural Financial
Science Management

Auditing
Economics Production

Law Accounting

1. Auditing and Accounting: Auditing checks financial statements, which are the result of the
accounting process
2. Auditing and Law: Auditors need to know business laws that affect the entity they're
auditing
3. Auditing and Economics: Auditors should understand the economic environment that
influences their client's business.
4. Auditing and Behavioral Science: Knowledge of human behavior is crucial for auditors to
do their job effectively.

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5. Auditing and Statistics & Mathematics: Auditors use statistics and math to draw
meaningful conclusions and verify inventories.
6. Auditing and Data Processing: Electronic Data Processing (EDP) auditing is becoming its
own field of expertise.
7. Auditing and Financial Management: Auditors need to understand financial techniques
like managing working capital, funds flow, ratio analysis, and capital budgeting.
8. Auditing and Production: A good auditor grasps their client's business functions, including
production, cost systems, and marketing, for a comprehensive audit.

OBJECTIVES OF AUDIT

The objectives of an audit, as defined by SA-200 "Overall Objectives of the Independent

Auditor and the Conduct of an Audit in Accordance with Standards on Auditing," can be
summarized as follows:

a) To obtain reasonable assurance about the accuracy of the financial statements: The
primary objective of an audit is to assess and provide reasonable assurance that the financial
statements are free from material misstatements, whether they result from fraud or error.
This reasonable assurance enables the auditor to express an opinion on whether the financial
statements, taken as a whole, are prepared in accordance with the relevant financial
reporting framework.
b) To report on the financial statements and communicate findings: The auditor is
responsible for reporting on the financial statements and communicating their findings in
accordance with the requirements set forth in the Standards on Auditing (SAs). This
communication may include any significant issues, findings, or concerns that the auditor
identifies during the audit process, which may be relevant to the users of the financial
statements.

An analysis of above brings out following points clearly: -

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 Auditor's Objective: The auditor's main goal is to provide "reasonable assurance" that
financial statements are free from significant mistakes, whether caused by fraud or errors.
This is not a complete guarantee but a high level of confidence.
 Fraud or Error: Misstatements in financial statements can happen because of fraud, error,
or both. The auditor's job is to make sure the financial statements are accurate overall.
 Expressing an Opinion: When the auditor is reasonably sure that the financial statements
are free from significant errors, they can express an opinion on whether the statements follow
the rules of the financial reporting framework.
 Reporting the Opinion: The auditor shares their opinion through a written report,
following the auditing standards. This report communicates their findings to stakeholders.

SCOPE OF AUDIT-WHAT IT INCLUDES

The scope of an audit refers to what the audit covers. Audits aim to increase the trust of
financial statement users, like shareholders, employees, and regulators. This trust is built
through the auditor's opinion on whether the financial statements follow the established
rules. In simpler terms, the scope of an audit is what the audit checks to make financial
statements more trustworthy.

The following points are included in scope of audit of financial statements

a) Coverage of All Aspects: Auditors must examine all aspects of the company relevant to the
financial statements. For instance, they check not only the sales and expenses but also things
like employee payroll, inventory, and loans.
b) Reliable Information: Auditors need to be reasonably sure that the data in the company's
accounting records and other documents, like bills and vouchers, is dependable and enough
to create accurate financial statements. For example, they check that sales and expenses are
recorded correctly.
c) Proper Disclosure: Auditors also ensure that all the necessary information is correctly
presented in the financial statements, and they consider legal requirements. For instance,
they check if the company properly reports things like changes in accounting policies.

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d) Historical Financial Information: Financial statements are like a history book of the
company's financial activities. For example, when you see a sale listed on the financial
statement, it's a record of a past event – the sale that happened in the past.

SCOPE OF AUDIT-WHAT IT DOES NOT INCLUDE

The scope of audit is general and broad, focusing on obtaining reasonable assurance about
the overall accuracy and reliability of financial statements. Auditors are not expected to
possess expertise in specific areas outside their domain, such as assessing the physical
condition of machinery or determining the suitability and lifespan of buildings. They also do
not authenticate documents or conduct official investigations into alleged wrongdoing. In
contrast, investigation is a focused and specific examination often prompted by suspicion of
fraud, involving a critical examination of accounts with a specialized purpose. The key
distinction lies in the broad and general nature of audit, seeking assurance on the financial
statements as a whole, compared to the specific and narrow focus of investigation on
particular concerns or allegations.

INHERENT LIMITATIONS OF AUDIT

Certainly, in simple terms, there are inherent limitations in the audit process that prevent
auditors from being absolutely certain that financial statements are completely free from
errors or fraud. These limitations are due to several factors:

1. Nature of Financial Reporting: Financial statements involve judgments and uncertainties.

Auditors can't guarantee that there are no significant mistakes in the statements due to fraud
or errors. For example, if employees collude to fake purchase records, internal controls may
fail.
2. Nature of Audit Procedures: Auditors use procedures to collect evidence, but practical and
legal limits mean they can't examine every transaction. Management may not provide all

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information, and sometimes, they might be involved in fraud, making it hard for auditors to
detect.
3. Not an Investigation: Audits are not official investigations, so they can't uncover all fraud
or errors.
4. Timeliness and Relevance: Information can become outdated, and auditors might rely on
old data that's no longer accurate. This means auditors have to balance information reliability
with the cost of obtaining it.
5. Future Events: Unexpected events can severely affect a company, and auditors can't
predict or prevent these events.

WHAT IS AN ENGAGEMENT

An engagement, in the context of auditing, is a formal agreement between an auditor and a

client. This agreement is documented in an engagement letter and outlines the auditor's
commitment to provide auditing services. It's like a contract specifying what the auditor will
do for the client.

EXTERNAL AUDIT ENGAGEMENTS

In simple terms, external audit engagements are formal agreements where external auditors
review a company's financial statements to increase the confidence of the people who rely
on those statements. This is typically done to provide reasonable assurance that the financial
statements are accurate. For example, in India, companies are legally required to have their
annual financial accounts audited by an external auditor. Even non-corporate entities may
opt for external audits to enjoy the advantages of this assurance. It's like a financial check-up
conducted by an independent expert to ensure everything is in order.

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BENEFITS OF AUDIT-WHY AUDIT IS NEEDED

1) High-Quality Information: Audited accounts provide reliable and top-quality information.

They follow global auditing standards, giving users confidence in the data's accuracy.
2) Shareholder Confidence: Shareholders, who may not be involved in daily company
operations, need assurance that financial information is trustworthy. An audit safeguards
their interests by providing an independent review.
3) Preventing Fraud: The fear of being caught in an audit acts as a deterrent for employees,
reducing the likelihood of fraud.
4) Tax Determination: Government authorities use audited financial statements to calculate
tax obligations.
5) Lending Decisions: Lenders and bankers rely on audited statements to decide whether to
lend money to a company or not.
6) Fraud Detection: Audits can uncover fraud or errors that may have occurred.
7) Controls Evaluation: Audits assess the effectiveness of various controls within a company,
highlighting any deficiencies that need attention

AUDIT- MANDATORY OR VOLUNTARY

Audits are not always legally mandatory. Some entities, like companies, are legally required
to have their accounts audited, while non-corporate entities may need audits due to tax laws.
Others, like schools, may choose to get audits to secure government grants. However, many
entities voluntarily opt for audits because they see the benefits of the process and may have
internal rules in place that require audits for those advantages.

WHO APPOINTS AN AUDITOR

Auditors are typically chosen by the owners of a business or, in some cases, by government
authorities as required by laws and regulations. For example, in companies, shareholders
appoint auditors at the Annual General Meeting. Government companies might have auditors
appointed by the Comptroller and Auditor General of India, an independent constitutional

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authority. In the case of a partnership firm, the partners appoint the auditor. There are also
situations where government authorities appoint auditors, such as under tax laws. The key is
that auditors are selected based on specific rules and responsibilities outlined in various laws
and regulations.

MEANING OF ASSURANCE ENGAGEMENT

An "assurance engagement" is when a professional (practitioner) provides a conclusion to
increase the confidence of users (other than the responsible party) regarding the accuracy of
specific information compared to certain criteria. In simple terms, it's a service where an
expert offers their opinion to give users greater confidence in the reliability of certain
information, helping them make more informed decisions with reduced risk of errors.

ELEMENTS OF AN ASSURANCE ENGAGEMENT

a) Three-Party Relationship: In an assurance engagement, there are three main parties

involved: the practitioner (the one providing assurance), the responsible party (responsible
for the subject matter), and the intended users (who receive and use the assurance report).
b) Appropriate Subject Matter: This refers to the information that the practitioner will
examine. For example, in financial audits, it's the financial information in the statements.
c) Suitable Criteria: These are the standards or benchmarks used to evaluate the subject
matter. They can be laws, rules, regulations, or industry standards.
d) Sufficient and Appropriate Evidence: The practitioner collects evidence to support their
conclusions. "Sufficient" refers to having enough evidence, and "appropriate" means the
evidence is of good quality.
e) Written Assurance Report: The outcome of an assurance engagement is a written report
that conveys the practitioner's conclusion about the subject matter. This report provides
assurance to the intended users.

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MEANING OF REVIEW; AUDIT VS. REVIEW

An audit gives a higher level of confidence, called "reasonable assurance," by thoroughly

examining financial statements. On the other hand, a review provides a lower level of
confidence, termed "limited assurance," by conducting fewer checks and gathering less
evidence. Both audit and review focus on historical financial information in financial
statements.

TYPES OF ASSURANCE ENGAGEMENTS- REASONABLE ASSURANCE ENGAGEMENT VS.

LIMITED ASSURANCE ENGAGEMENT

Assurance engagements offer varying degrees of confidence to users. An audit, like a

reasonable assurance engagement, provides a high level of confidence. In contrast, a review,
which is a limited assurance engagement, offers a moderate level of confidence, lower than
an audit.

Aspect Reasonable Assurance Limited Assurance

Engagement Engagement
Level of Assurance Provides a high level of Provides a lower level of
assurance assurance compared to
reasonable assurance
engagement
Procedures Involves elaborate and Performs fewer procedures
extensive procedures to compared to a reasonable
obtain sufficient assurance engagement
appropriate evidence

Conclusions Draws reasonable Involves obtaining sufficient

conclusions based on appropriate evidence to
sufficient appropriate draw limited conclusions
evidence.

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 Examples An example of a reasonable An example of a limited
assurance engagement is an assurance engagement is a
audit engagement. review engagement
.

QUALITIES OF AUDITOR

An auditor plays a vital role in reporting on financial matters of businesses and institutions,
navigating the challenges of human errors and fraud. Essential qualities for auditors include
tact, caution, integrity, patience, and expertise in accounting principles. These traits, coupled
with technical training, enable auditors to critically review financial statements and maintain
a position of trust. Comprehensive knowledge of accounting principles is fundamental for
effective auditing.

ENGAGEMENT AND QUALITY CONTROL STANDARDS: AN OVERVIEW

The following Standards issued under authority of ICAI Council are collectively known as
Engagement Standards:

 Standards on Auditing (SAs) are used for auditing historical financial information, ensuring
high-quality standards and guidance for financial statement audits.
 Standards on Review Engagements (SREs) apply to the review of historical financial
information, setting quality standards for review engagements.
 Standards on Assurance Engagements (SAEs) are used for assurance engagements other
than audits and reviews of historical financial information, providing guidance for various
assurance services.
 Standards on Related Services (SRSs) apply to services such as agreed-upon procedures,
compilation engagements, and related service engagements, establishing standards and
guidelines for these activities.

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STANDARDS ON AUDITING

Standards on Auditing are guidelines for independent auditors when auditing financial
statements. They set high-quality benchmarks for auditing financial information, particularly
historical data. These standards cover various aspects of the audit process, such as the
auditor's objectives, documentation, risk assessment, planning, sampling, gathering
evidence, and forming opinions for reporting on financial statements. In short, they provide
a framework for conducting thorough and reliable financial audits.

 SA 200 (Overall Objectives): It outlines the core goals for auditors and how audits should
be conducted in line with auditing standards.
 SA 230 (Audit Documentation): This standard emphasizes the importance of maintaining
organized records of audit procedures, findings, and conclusions.
 SA 315 (Risk Assessment): It guides auditors in identifying and evaluating the risks of
significant errors or fraud in financial statements by understanding the entity and its
environment.
 SA 500 (Audit Evidence): This standard explains the types of evidence that auditors should
collect to support their audit conclusions.
 Revised SA 700 (Opinion and Reporting): It sets guidelines for auditors to form opinions
based on audit findings and effectively report those opinions on the accuracy and reliability
of financial statements.

STANDARDS ON REVIEW ENGAGEMENTS

Standards on review engagements are used when reviewing financial statements. Reviews
provide a lower level of assurance compared to audits because they involve fewer
procedures. However, even in a review, the auditor obtains sufficient appropriate evidence,
as seen in cases like reviewing interim financial information for reliability.

Examples of Standards on Review engagements are:

 SRE 2400 (Revised) - Guidelines for Reviewing Historical Financial Statements
 SRE 2410 - Reviewing Interim Financial Information Conducted by the Independent Auditor
of the Entity

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STANDARDS ON ASSURANCE ENGAGEMENTS
Standards on Assurance Engagements (SAEs) are a set of guidelines used in assurance
engagements that deal with subject matters other than historical financial information. These
standards apply when the assurance engagement does not involve the "audit" or "review" of
historical financial information. For example, SAEs are used for assurance engagements
related to prospective financial information or providing assurance on non-financial matters
such as the design and operation of internal controls in an entity.

Examples of Standards on Assurance Engagements are:

 SAE 3400 - Examining Future Financial Information
 SAE 3420 - Assurance for Pro Forma Financial Information in a Prospectus

STANDARDS ON RELATED SERVICES

Related services standards pertain to tasks like performing agreed-upon procedures on
specific financial data or assisting in preparing historical financial information. For instance,
these standards cover engagements involving individual financial items, balance sheets, or
complete financial statements. They clarify that these tasks are not assurance engagements
and no opinions are expressed. Examples of related services standards include SRS 4400 for
agreed-upon procedures and SRS 4410 (Revised) for compilation engagements. These
standards, along with auditing, review, and assurance standards, collectively form the
Engagement Standards.

STANDARDS ON QUALITY CONTROL

Standards on Quality Control (SQC) outline a firm's responsibilities for maintaining a system
of quality control when conducting audits, reviews, and other assurance and related service
engagements. SQC 1 is a key standard in this area, requiring auditors and practitioners to
establish quality control systems that ensure compliance with professional standards and
legal requirements. The primary goal is to maintain quality and ensure the issuance of
appropriate reports when providing services covered by engagement standards.

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WHY ARE STANDARDS NEEDED
Standards are like rules that help auditors perform audits up to global standards. They
enhance the quality of financial reporting, making it easier for users to make informed
decisions. Standards also bring consistency to the audit process, ensuring that all audits follow
the same rules. They provide professional accountants with the knowledge and skills they
need to do their job well and, most importantly, they ensure that audits are of high quality

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