Unit Two: Auditing profession and GAAS

2.1: Auditing profession

2.2: Generally Accepted Auditing Standards
2.2: Types of Audit reports
2.3: Parts of audit reports
2.4: Conditions for issuing different audit reports
2.5: Materiality and Auditors decisions
 Emergence of need for Audit Reports
 The prevalence of great business opportunities created
by growth in technology, improved communication &
transportation and expanding global markets proved owner
manager source of capital to be no more capable of
supporting the speed of entry to new markets
internationally nor the wealth-creating potential of the
enterprises.
 This lead to the need to pool resources through savings
of the community as a whole and hence formation of
large companies.
 The result has been the growth of sophisticated securities
markets and credit-granting institutions serving the
financial needs of these large national, and increasingly
international, corporations.
 Emergence of need for Audit Reports
 The flow of investor funds to the corporations and the
whole process of allocation of financial resources
through the securities markets have become
dependent to a very large extent on financial reports
made by company management.
 One of the most important characteristics of these
corporations is the fact that their ownership is almost
totally separated from their management
 Management has control over the accounting systems.
 They are not only responsible for the financial reports to
investors, but they also have the authority to determine
the way in which the information is presented.
 Emergence of need for Audit Reports

 Investors and creditors may have different objectives

than management (e.g., management prefers higher
salaries and benefits (expenses), whereas investors
wish higher profits and dividends).
 Investors and creditors must depend on fair reporting
of the financial statements.
 To give them confidence in the financial statements, an
auditor provides an independent and expert opinion on
the fairness of the reports, called an audit opinion.
User Demand for Reliable Information
 Today’s information
More complex
Demanded by remote users
Demanded in a more timely manner
Has far reaching consequences
 Information risk
The risk that the information disseminated by a
company will be materially false or misleading.
Users demand an independent third party assessment
of the information
 Business risk
The risk that an entity will fail to meet its stated business
objectives

1-5
 Why Audit ?

 Legal and Contractual Requirements

 Restrictive Covenants in Debt Agreements
 Modern Corporation Setup –
 Absentee Stockholders and professional Managers
 Principal –Agent Relationships
 Lack on information symmetry
 Conflicts of Interest
 Cost Effective Monitoring Device
 The Auditor, Corporations and Financial
Information
i. Audits Required
• In most countries, audits are now legally required for
some types of companies (statutory audits)
– E.g., listed companies, companies receiving
government money, certain industries
• Major stock exchange centers/ Bourses (including NYSE,
NASDAQ, London Stock Exchange, Tokyo NIKKEI, and
Frankfurt DAX) have listing rules that require all
companies to have an audited annual report.
 The Auditor, Corporations and Financial
Information
ii. The Importance of Auditing
 It can be said that the function of auditing is to lend
credibility to the financial statements.
 The financial statements are the responsibility of
management and the auditor’s responsibility is to lend
them credibility.
 By the audit process, the auditor enhances the
usefulness and the value of the financial statements,
but also increases the credibility of other non-audited
information released by management.
The Role of Auditing
iii. The Expectations of Auditors
• The importance of the company as a potential generator of wealth
is increasingly understood, and so is the impact that a company’s
activities have on society and the environment.
• This has led to the expectation by investors that more information
than just financial statements should be provided about a company.
• Public expectations go further and include questions such as:
1. Is the company a going concern?
2. Is it free of fraud?
3. Is it managed properly?
4. Is there integrity in its database?
5. Do directors have proper and adequate information to make decisions?
6. Are there adequate controls?
7. What effect do the company’s products and by-products have on the
environment?
 THEORIES ON THE DEMAND FOR
AUDITING
A theory is defined in Encyclopedia Britannica as follows:

 Systematic ideational structure of broad scope,

conceived by the human imagination, that
encompasses a family of empirical (experiential) laws
regarding regularities existing in objects and events,
both observed and posited.
 A scientific theory is a structure suggested by these
laws and is devised to explain them in a scientifically
rational manner.
 THEORIES ON THE DEMAND FOR
AUDITING
 Mautz and Sharaf (1961) define the purpose of theory in
the following way: “One reason, then, for a serious and
substantial investigation into the possibility and nature
of auditing theory is the hope that it will provide us with
solutions or, at least, clues to solutions, of problems
which we now find difficult”.
 Theories on the demand for auditing provide a general
framework for auditing, or at least for understanding
it.
 THEORIES ON THE DEMAND FOR
 Auditing theory AUDITING
 helps explain why auditing is needed in the first
place
 helps explain why some of the postulates and key
concepts of auditing are so important
 uncovers some of the laws that govern the audit
process and its activities.
 provides us with a framework for understanding
the relationships and interrelationships between
different parties of a firm.
 There are several different theories that may explain
the demand for audit Services.
 There are four important audit theories that explain the
demand for audit services:
1. The policeman theory
2. The lending credibility theory
3. The theory of inspired confidence
4. Agency Theory
 1. The policeman theory
 The policeman theory claims that the auditor is
responsible for searching, discovering and preventing
fraud.
 In the early 20th century this was certainly the case.
 However, more recently the main focus of auditors has
been to provide reasonable assurance and verify the
truth and fairness of the financial statements.
 The detection of fraud is, however, still a hot topic in
the debate on the auditor's responsibilities, and typically
after events where financial statement frauds have been
revealed, the pressure increases on increasing the
responsibilities of auditors in detecting fraud.
2. The lending credibility theory
 The lending credibility theory suggests that the primary
function of the audit is to add credibility to the
financial statements.
 In this view the service that the auditors are selling to the
clients is credibility.
 Audited financial statements are seen to have elements
that increase the financial statement users’ confidence in
the figures presented by management.
 Under this it is believed that the quality of investment
decisions will improve when they are based on reliable
and credible information.
3.The theory of inspired confidence or Theory
of rational expectations
 Addresses both the demand and the supply for audit
services
 States that the demand for audit services is the direct
consequence of the participation of third parties or
outside stakeholders in the company.
 These parties demand accountability from the
management, in return for their investments in the
company.
 Accountability is realized through the issuance of
periodic financial reports.
 Theory of rational expectations
 Though, information provided by the management
could be biased due to conflict of interest, and outside
parties do not have direct means of monitoring, an audit
is required to assure the reliability of this
information.
 With regard to the supply of audit assurance, Limperg
(1932) suggests that the auditor should always strive to
meet the public expectations.
 4. Agency theory
 Agency theory (Watts and Zimmerman 1978, 1986a,
1986b) suggests that the auditor is appointed in the
interests of both the third parties as well as the
management.
 A company is viewed as a web of contracts.
 Several groups (suppliers, bankers, customers, employees
etc.) make some kind of contribution to the company for
a given price.
4. Agency theory
 The task of the management is to coordinate these
groups and contracts and try to optimize them by way
of:
 low price for purchased supplies,
 high price for sold goods,
 low interest rates for loans,
 high share prices and
 low wages for employees.
 In these relationships, management is the agent,
which tries to gain contributions from principals
(bankers, shareholders, employees etc).
 The role of the audit
 Related, and to some extent overlapping, with the four
theories discussed above, Wallace (1980) proposed three
hypotheses for explaining the role of the audit in free
and regulated markets:
1. the monitoring hypothesis,
2. the information hypothesis and
3. the insurance hypothesis.
 1. The monitoring hypothesis
 The monitoring hypothesis assumes that when
delegating decision-making power to one party, as
suggested in agency theory, the agent is motivated to
agree to be monitored if the benefits from such
activities exceed the related costs.
 This hypothesis is applicable to all co-operative
relationships in any organization, i.e, relationships
between:
 owners and managers
 employers and employees,
 creditors and shareholders,
 different levels of management in companies and
 Government and taxpayers(Wallace 1980 and 1987).
The monitoring hypothesis Cont…
 Beaver (1989) pointed out that the monitoring theory strives to solve
problems that arise due to moral hazard and information asymmetry
between the agent and the principal.
 Moral hazard is the problem of the agent possessing superior
information and thus having the opportunity to use it self-
interestedly at the expense of the principal (Beaver 1989).
 Arrow (1985) calls the two types of principal-agent problems
hidden action (moral hazard) and hidden information
(information asymmetry).
 To monitor and restrict the superior information position of
management, an independent actor called auditor is
contracted to inspect the information
 The audit reduces the agent’s chances to withhold material
information from the shareholders (Beaver 1989).
 2. The information hypothesis
 Financial reporting was earlier seen to be central to the
monitoring purposes
 Since the 1960’s the focus moved towards the need and
the provision of information to enable users to take
economic decisions (Higson 2003) which is the focus of
the information hypothesis
 One argument regarding the demand for audited
financial statements is that they provide information
that is useful in investors’ decision-making
 2. The information hypothesis
 The information hypothesis emphasizes that financial
information is needed by investors to determine market
values, which are the basis for rational investment
decisions in the absence of an explicit contract with the
agent (Wallace 1980).
 Fama and Laffer (1971) discuss three major benefits of
information:
 reduction of risk,
 improvement of decision-making and
 Provide gains from stock trade by investors
3. The insurance hypothesis
 The third hypothesis on how the demand for audits
evolves relates to management’s liability exposure
(Wallace 1980).
 The auditor and the auditee are jointly and severally
liable to third parties for losses attributable to defective
financial statements.
 The ability to shift financial responsibility for reported
data to an auditor lowers the expected loss from
litigation or related settlements to managers, creditors
and other professionals involved in the securities
market.
 The shift made is for high audit premium in exchange
for a guarantee or insurance from the auditor
 3. The insurance hypothesis
 There are four explanations why managers and other
professionals look for insurance from auditors rather
than an insurance company
 First, the audit function is so firmly established in
society that the decision of management not to hire an
auditor would strongly imply negligence or fraud on
the part of the managers of other professionals.
 Second, accounting firms have established in-house
legal departments to defend them in professional
liability suits.
 Third, the auditor facing a litigation suit is concerned
about his/her reputation
 Fourth, auditors have “deep pockets” relative to a
bankrupt or failing company that cannot pay.
Auditing profession

 To understand the importance of a code of ethics to auditors and

other professionals, one must understand the nature of a profession.
 Unfortunately there is no universally accepted definition of what

constitutes a profession. Yet for generations, certain types of

activities have been recognized as professions while others have
not.
 Medicine, law, engineering, theology are examples of disciplines

having long accorded professional status. Auditing is a relatively

newcomer to the ranks of the profession, but it has achieved
widespread recognition in recent times.
 A profession is a discipline that involves a responsibility to serve

the public.
Auditing profession

Auditing as a profession and just like other professions has some

common characteristics. The most important of these
characteristics are:
1. Responsibility to serve the public: Certified public accountants

or simply auditors are the representatives of the public

-creditors, stockholders, consumers, employees and other users of
financial reports.
 The role of the independent auditor is to assure that financial

statements are fair to all parties and not biased to benefit one
group at the expense of another.
 This responsibility to serve the public interest must be a basic

motivation for the professional.

 There is a saying in public accounting that “The public is our

only client.”
Auditing profession

 It has been claimed by public accountants that Auditing is

more responsible to the public than any other professions.
 This is because millions of clients might be affected if the
auditor is negligent in his professional act.
 Usually one client might be affected if the Physician or
attorney is negligent in his professional act.
 That is why public accountants say no profession is more
responsible to the public like auditing.
 Public accountant must maintain a high degree of
independence from their client if they are to serve the large
community.
Auditing profession

2. Complex Body of Knowledge: Auditing as a profession has

specialized body of knowledge that every member of the profession
should acquire through formal education.
 Auditing like other professions has complex accumulated body of
knowledge.
 Any practitioner or student of accounting and auditing has only to look
at the abundance of authoritative pronouncements governing financial
reports to realize that accounting and auditing are complex body of
knowledge.
 As the environment changes, accounting and auditing principles and
practices must adapt.
 The need for technical competence and familiarity with current
standards of practice is embodied in the code of professional conduct
Auditing profession

3. Standards of admission to the profession:

Obtaining a license to practice as certified public
accountant requires an individual to meet minimum
standards for education and experience.
The individual must also pass the CPA examination
showing mastery of the body of knowledge.
The admission to practice as public accountant is
restricted by legal and educational requirements so
as to provide quality service to the society.
Auditing profession

4. Professional Associations: There are a number of

professional associations which are devoted them selves
with the development of auditing principles and
standards. The ten generally accepted auditing standards
are the guidelines developed by AICPA.
5. Need for public confidence: Certified public accountants
must have the confidence of the public to be successful.
The CPAs product is credibility and hence the public
confidence is of special significance. With out public
confidence the attest function serves no useful purpose.
6. Professional Ethics
 Ethics can be defined broadly as a set of moral
principles or values.
 Each of us has such a set of values.
 We may or may not have considered them explicitly.
Need for Ethics
 Ethical behavior is necessary for a society to
function in an orderly manner.
 The need for ethics in society is sufficiently
important that many commonly held ethical values
are incorporated into laws.
 Professional Ethics: professional ethics refers 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.
Professional ethics in public accounting as in other
professions have been developed gradually and are still in a
process of change as the practice of accounting it self changes.
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 status of their discipline.
Ethical Dilemmas
 An ethical dilemma is a situation a person faces in
which a decision must be made about appropriate
behavior.
 Rationalizing Unethical Behavior
1. Everybody does it.
2. If it’s legal, it’s ethical.
3. Likelihood of discovery and consequences
Special Need for Ethical Conduct in Professions

 Our society has attached a special meaning to the

term professional.
 A professional is expected to conduct himself or
herself at a higher level than most other
members of society.
 The AICPA Code of Professional Conduct
Code of Professional Conduct
Ideal standards of ethical conduct
Principles stated in philosophical terms.
They are not enforceable.

Minimum standards of ethical

Rules of
conduct stated as specific rules.
conduct
They are enforceable.

Interpretation of the rules of conduct by

Interpretations
the AICPA Division of Professional Ethics.
of the rules
They are not enforceable, but a
of conduct
practitioner must justify departure.
Code of Professional Conduct
Published explanations and answers
to questions about the rules of
conduct submitted to the AICPA by
Ethical
practitioners and others interested
rulings
in ethical requirements.
They are not enforceable, but a
practitioner must justify departure.
Ethical Principles

1. Responsibilities:
Professionals should exercise sensitive and
moral judgments in all their activities.

2. The public interest:

Members should accept the obligation to act
in a way that will serve and honor the public.
Ethical Principles

3. Integrity:
Members should perform all responsibilities
with integrity to maintain public confidence.

4. Objectivity and independence:

Members should be objective, independent,
and free of conflicts of interest.
Ethical Principles

5. Due care:
Members should observe the profession’s
standards and strive to improve competence.

6. Scope and nature of services:

A member in public practice should observe
the Code of Professional Conduct.
 Standards of Conduct

Ideal conduct
Principles
by practitioners

Minimum level
Rules of
of conduct by
conduct
practitioners Substandard
conduct
Auditing profession

The AICPA code of professional ethics considers the following to be

followed by auditors in the conduct of professional relations with
others.
1. Integrity: An auditor should be straight forward, honest and
sincere in his approach to his professional work. By integrity it
means honorable, upright, courageous and not being two faced.
2. Objectivity: An auditor should be fair and should not allow bias to
override his objectivity when reporting his opinion. He should
maintain an impartial attitude. 
He obtains the evidence needed to form an opinion and his
opinion is based on that evidence alone. He is not subjective in
forming his opinion.
3. Confidentiality: Usually auditors have unrestricted access,
even to the confidential documents, of the client while they
are conducting an audit.
Thus an auditor should respect the confidentiality of the
information acquired in the course of his work and should not
disclose any such information to a third party with out
specific authority or unless there is a legal or professional
duty to disclose.
A member acquiring information in the course of professional
work should neither use nor appear to use that information for
his personal advantage or for the advantage of any third party.
Auditing profession
4. Independence: When in public practice, an auditor
should both be and appear to be free of any interest
which might be regarded, what ever its actual effect,
as being incompatible with integrity and objectivity.
Auditor is independent of management i.e. he is not
under the control or influence of management.
5. Caring for others: Be caring, kind and passionate,
be of service to others; help those in need and avoid
harming others.
Auditing profession
6. Accountability: An auditor should be accountable,
accept responsibility for decisions, setting an
example for others.
7. Due care: This requires competence, and
diligence. Competence is the product of education
and experience, and diligence involves steady,
earnest and energetic application and effort in
performing professional services.
Generally Accepted Auditing standards

 In order to maintain high level of quality work,

auditors need to have some standards in accordance
with which they perform their activities.
 This section discusses the authoritative rules for
measuring the quality of audit work.
 Standards are authoritative rules for measuring
the quality of performance.
Generally Accepted Auditing standards

 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
 Auditing standards are general guidelines to aid
auditors in fulfilling their professional
responsibilities in the audit of financial statements.
 What are the standards developed for the public
accounting profession?
Generally Accepted Auditing standards

 AICPA has set forth ten generally accepted auditing

standards: These ten auditing standards are classified
in to three major groups as general standards, field
work standards and reporting standards.
1. General standards: The general standards relate to
the personal integrity and professional
qualifications of the auditors.
These standards stress on competence,
independence and due professional care by the
auditor. These standards are:
Generally Accepted Auditing standards

A) Technical Training and proficiency: An audit

examination should be performed by a person or
persons having adequate technical training and
proficiency as an auditor.
 This requirement is usually interpreted to mean

college or university education in accounting and

auditing, substantial public accounting experience,
ability to use procedures suitable for computer based
systems and technical knowledge of the industry
being audited.
Generally Accepted Auditing standards

B) Independence: In all matters relating to the assignment;

independence is to be maintained by the auditors.
This is the most important auditing standard.
Independence means avoiding relationships that may
impair the auditor’s objectivity.
It is not enough that auditors are independent in fact but
they have to be also perceived as being independent in
appearance.
Otherwise, the public can loose confidence in the auditor’s
ability to report truthfully on the financial statements.
Generally Accepted Auditing standards

Independence may be broadly thought of as having four facets: these are:

1. Financial independence: financial independence relates to not having a financial
interest in the client.
2. Independence in mental attitude: Independence in mental attitude is essential to
achieve independence in fact.
3. Investigative independence: this means that the auditor has the time and
resources to obtain competent and sufficient audit evidence and that the auditor
has access to all evidence needed to reach the proper opinion as to the fairness of
the financial statements. Investigative independence will be impaired if there was
a deadline so that the job was rushed
4. Reporting independence: means reporting at a sufficiently high level that the
report will be acted on. If an auditor is accountable to report to the management,
then the auditor would not have reporting independence. On the other hand, if the
auditor is accountable to an audit committee (made up of independent board of
directors) then the auditor would have reporting independence.
Generally Accepted Auditing standards

Independence has two distinct aspects.

First, the public accountant 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.
Mechanisms to strengthen Independence:
Auditor’s independence may be addressed in statutory
law, professional standards and audit firm policy.
Generally Accepted Auditing standards

Independence may be addressed by:

 prohibiting owners of accounting firms and their staff from
holding shares in, lending to, or otherwise having a beneficial
interest , either directly or indirectly in audit clients
 Prohibiting owners and their staff from receiving any benefits
from client organizations, other than through the receiving of
audit fees.
 Prohibiting owners and their staff from holding any office,
including the office of director, in client organizations
 Prohibiting the undertaking of consulting work such as taxation
and corporate advising work for the existing audit clients.
Generally Accepted Auditing standards

C) Due professional care: The third general standard

requires due care in the performance of all aspects of
auditing. Simply stated the auditor is professionally
responsible for fulfilling his /her duties diligently and
carefully.
Due care includes consideration of the completeness of
the working papers, the sufficiency of the audit evidence,
and the appropriateness of the audit report. As a
professional, the auditor must avoid negligence and bad
faith. This standard requires auditors to carry out their
work in an alert and diligent manner
Generally Accepted Auditing standards

2- Field work standards: The three standards of field work

relate to accumulation and evaluating evidence sufficient
for the auditors to express an opinion on the financial
statements.
Auditors cannot effectively satisfy the general standards
requiring due professional care if they have not also
satisfied the standards of field work.
The field work standard involves
adequate planning,
sufficient understanding of internal control and
sufficient and competent evidence.
Generally Accepted Auditing standards

A) Sufficient understanding of internal control: One of the

most widely accepted concepts in the theory and practice of
auditing is the importance of the client’s internal control
structure to generate reliable financial information.
An excellent internal control structure provides strong
assurance that the client’s records are dependable and
that its assets are protected.
A proper understanding of the internal control helps the
auditor to determine the appropriate amount and quality
of evidence.
Thus, the auditor’s assessment of internal control has great
impact on the length and nature of the audit process.
Generally Accepted Auditing standards

B) Adequate planning and supervision: The first standard

of field work deals with ascertaining that the engagement
is sufficiently planned to ensure an adequate audit and
adequate supervision of assistants.
Proper planning can help to effectively detect material
misstatements on the financial statements and to
complete the audit engagement in a reasonable amount
of time.
Supervision is essential in auditing because a considerable
portion of the field work is done by less experienced staff
members.
Generally Accepted Auditing standards

C) Sufficient and competent evidence: The third standard

of fieldwork requires that the auditors should gather
sufficient and competent evidence to have a basis for
expressing an opinion on the financial statements.
The decision as to how much evidence to accumulate in
a given set of circumstances requires professional
judgment.
The term sufficient refers to the quantity of
information to be gathered while competency refers
to the quality of evidences, as some forms of evidence
are stronger and more convincing than others.
Generally Accepted Auditing standards

3-Standards of Reporting: The ultimate objective of

independent auditors is to report on the findings of the
audit.
The reporting is guided by reporting standards of
GAAS.
The standards of reporting deals with
 Generally accepted accounting principles (GAAP),
 consistency,
 adequate disclosure and
 report content.
Generally Accepted Auditing standards

These reporting standards can be explained as follows:

1. The report shall state whether the financial statements are
presented in accordance with GAAPs.
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 that an opinion can not be expressed.
 When an over all opinion can not be expressed, the
reasons should be stated. In all cases where an
auditor’s name is associated with financial
statements, the report shall contain a clear-cut
indication of the extent of the auditor’s
examination and the degree of responsibility he/she
is taking.
Generally Accepted Auditing standards

Case 1: Assume Mr. Dawud, general manager of AB trading,

applied for a bank loan and was informed by the banker that
audited financial statements of the business must be submitted
before the bank could consider the loan application.
Mr.Dawud agreed with Tomas, CPA, to perform an audit.
 Mr. Dawud informed Tomas that audited financial statements
were required by the bank and that the audit must be
completed within two weeks and Mr. Dawud promised to pay
Tomas a fixed fee plus a bonus if the audit is completed with
in two weeks and the bank approved the loan. Tomas, CPA,
agreed and accepted the engagement.
Generally Accepted Auditing standards

 The CPA, Tomas, hired two fresh accounting graduates to

conduct the audit and spent several hours telling them
exactly what to do and he told them not to spend time
reviewing internal control but instead, to concentrate on
proving the mathematical accuracy of the ledger accounts
and summarizing the data in the accounting records that
support the company’s financial statements. The audit was
completed with in two weeks and Tomas issued audit report.
 Instruction: Exhaustively identify the auditing principles
that were violated By Tomas and support your answer with
justification.
Audit reports
The audit report is the final step of the audit process.
The financial statements on which you prepare an
audit report are the balance sheet, the income
statement, the statement of retained earnings and the
statements of cash flow.
The auditing profession recognizes the need for
uniformity in reporting as a means of avoiding
confusion.
To avoid confusion and misrepresentation of an audit
report there should be uniformity in reporting.
Audit reports
The AICPA has developed the following reporting standards.
1. The report shall state whether the financial statements are presented in
conformity with Generally Accepted Accounting Principles.
2. The report shall state whether or not such principles have been consistently
followed or not.
3. Informative disclosures in the financial statements are to be regarded as
reasonably adequate unless otherwise stated in the report.
4. The report shall contain either an expression of an opinion regarding the
financial statements taken as a whole, or an assertion to the effect that an
opinion cannot be expressed.
When an overall opinion cannot be expressed, the reasons should be stated.
In all cases where an auditor’s name is associated with the financial statements,
the report should contain a clear-cut indication of the character of the auditor’s
examination, if any, and the degree of responsibility he/she is taking.
Audit reports
 The profession recognizes the need for uniformity
in reporting as a means of avoiding confusion.
 The professional standards have defined and
enumerated the types of audit reports that should be
included with the financial statements.
 The wording of audit reports is reasonably
uniform, but different audit reports are
appropriate for different circumstances.
Components of audit report

 Auditors issue different types of reports based on their

findings. Later, in this chapter, we shall see the types of
reports issued by auditors.
 One of the reports auditors issue is the standard
unqualified audit report. The standard audit report
(Unqualified) contains three paragraphs, namely the
introductory paragraph, the scope paragraph, and the
opinion paragraph.
 Each part of the auditor report is significant in terms of the
information conveyed to the user and the responsibility
assumed by the auditor.
Components of audit report

standard unqualified report has seven parts.

 Report Title: The auditing standard requires that the report be
titled and that the title include the word Independent. The
appropriate title would be “Independent auditor’s report, or
Report of independent auditors.” The requirement that the title
include the word “independent” is intended to convey to users
that the audit was unbiased in all aspects of the engagement. 
 Address: The report is usually addressed to the company, its
stockholders or the board of directors or combinations of
these. If you are appointed by the stockholders at the annual
meeting, you have to write the audit report addressing to them.
Components of audit report

Introductory paragraph: This is the first paragraph of the audit

report and it does three things:
 It makes the simple statement that the audit firm has done an
audit. This is intended to distinguish the report from a
compilation or review report.
 It lists the financial statements that were audited, including the
balance sheet, income statement, statement of retained earnings
and cash flow statements.
 The introductory paragraph states that the statements are the
responsibility of management and that the auditor’s responsibility
is to express an opinion on the financial statements based on an
audit.
Components of audit report

 Scope paragraph: The scope paragraph describes what

the auditor has performed during the audit.
Specifically, it states whether the audit was conducted in
accordance with Generally Accepted Auditing Standards
(GAAS). It also states that the GAAS requirement that
an audit be planned to provide reasonable assurance that
the financial statements are free of material
misstatement. The scope paragraph states that the audit
is designed to obtain reasonable assurance about whether
the statements are free of material misstatements.
Components of audit report

 The inclusion of the word “material” conveys that auditors are

responsible only to search for significant misstatements; not
minor errors that do not affect users’ decisions.
 The use of the term “reasonable assurance” is intended to

indicate that an audit cannot be expected to eliminate completely

the possibility that a material error or irregularity will exist in
the financial statements. In other words, an audit provides a high
level of assurance, but it is not a guarantee.
 The scope paragraph also discusses the audit evidence

accumulated and states that the auditor believes the evidence

accumulated was appropriate for the circumstances to express
the opinion presented.
 The word test-basis indicates that sampling was used rather than

an audit of every transaction and amount on the statements.

Components of audit report

 Opinion Paragraph: The final paragraph in the standard report

states the auditor’s conclusions based on the results of the audit
examination.
 This paragraph contains the auditor’s opinion on whether the
financial statements are in conformity with GAAP.
 Management is responsible for preparing the financial statements.
The responsibility of the auditor is to audit and express an opinion
on their fairness. This paragraph describes the auditor’s findings.
These findings are expressed in terms of whether the financial
statements are presented in accordance with generally accepted
accounting principles.
 The audit report must contain either an expression of opinion or
an assertion to the effect that an opinion can not be rendered
and the reasons for this.
Components of audit report

 Name of the audit firm and signature: The name and the
signature identify the audit firm or practitioner that has
performed the audit. Typically, the firm’s name is used, since
the entire audit firm has the legal and professional
responsibility to make certain the quality of the audit meets
professional standards.
 Date of audit report: The appropriate date of the audit report
is the one on which the field work has been completed. This
date is important because it represents the time limit on the
auditors’ responsibility. The auditor does not have any
responsibility to make any enquiries after this date.
Audit reports
Types of audit report: There are four types of audit
reports that might be issued by the auditors.
These are:
1. An unqualified opinion
2. Qualified opinion
3. An adverse opinion
4. Disclaimer opinion
Audit reports
 The Unqualified report: The most common type of
audit report is the standard unqualified audit report.
 This report represents a “clean bill of health” and
may be issued when
 there are no material departures from generally
accepted accounting principles,
 no significant scope limitations preventing the
gathering of necessary evidence and
 when no conditions requiring explanatory language
exist.
Audit reports
The unqualified report is issued when the following conditions have been
met:
 All statements- balance sheet, income statement, statement of retained

earnings and cash flow statements are included in the audited financial
statements
 When standards of auditing are applied in all respects of the engagement.

 When sufficient evidence has been accumulated and the auditor has

conducted the audit in a manner that enables him to conclude that three
standards of field work have been met.
 The financial statements are presented in accordance with generally

accepted accounting principles. This also means that the adequate

disclosures have been included in the footnotes and other parts of the
financial statements.
 There are no circumstances requiring the addition of an explanatory

paragraph or modification of the wording of the report.

Sample unqualified audit report

 Unqualified audit report

Audit reports
Qualified opinion: This type of opinion is still a positive opinion
and may result from limitations on the scope of the audit or
failure to follow generally accepted accounting principles. 
Auditors may issue this type of opinion when:
 They do not agree with the accounting principles used in

preparing financial statements or when they believe that the

disclosures in the financial statements are inadequate.
 A change in accounting principles is not applied properly as per

GAAP and is not adequately disclosed in the financial

statements
 There are limitations on scope of examination

 There is major uncertainty affecting a client’s business.

Audit reports
 In general qualified opinion is issued when the auditors’
examination is restricted as to its scope or the financial statements
depart from generally accepted accounting principles.
 A qualified opinion is still a positive opinion; it asserts that the
presentation in the financial statements, viewed as a whole is fair.
 The qualified opinion has a separate explanatory paragraph
before the opinion paragraph disclosing the reasons for the
qualification.
 When ever the auditor issues a qualified report, he/she must use the
term except for in the opinion paragraph. The implication is that the
auditor is satisfied that the overall financial statements are fairly
stated except for a particular aspect of them
Sample qualified audit report
 Qualified Audit report
Audit reports
Adverse opinion: this is a negative opinion, asserting that the
financial statements are not fairly presented.
It is issued when the exceptions to the presentations in the
financial statements are so significant that a qualified opinion
would be an inadequate warning to the users of those
statements.
This is a stronger form of except-for opinion – the disagreement
is so material that the financial statements as a whole are
misleading.
 This type of statement is used only when the auditor believes the

overall financial statements are so materially or extremely

misstated or misleading that they do not present fairly the financial
position or results of operations and cash flows in conformity with
generally accepted accounting principles.
Audit reports
 The adverse opinion report can arise only when the auditor has the
knowledge, after adequate and satisfactory investigation, of the
absence of conformity.
 That is when the auditors express an adverse opinion; they must
have accumulated sufficient appropriate evidence to support their
unfavorable opinion.
 Presumably creditors and stockholders would not provide debt or
equity capital to the client if the auditor issues adverse opinion to
the financial statements of the client.
 Thus, the client usually will make whatever changes in the
financial statements that the auditors require in order to avoid
receiving an adverse opinion.
Audit reports
 The adverse opinion like the qualified opinion has
a separate explanatory paragraph, before the
opinion paragraph to state the reasons for issuing
an adverse opinion and the principal effect of the
adverse opinion on the client’s financial position
and operating results.
 In the opinion paragraph of adverse opinion the
auditors use the negative word “do not present
fairly”.
Sample adverse audit report
 Sample Adverse Audit reports.docx
Audit reports
 Disclaimer Opinion: This opinion is also called denial opinion.
This type of audit opinion is issued whenever the auditor has been
unable to satisfy him self or her self that the overall financial
statements are fairly presented.
 The necessity for disclaiming an opinion may arise under the

following conditions:
 If there has been a severe scope limitation that prevents the

auditor from obtaining sufficient and competent audit evidence;

 If the auditor cannot satisfy him self or herself by applying other

procedures;
 If the effect of the scope limitation is so significant that the auditor

can not form an opinion as to the fairness of the financial

statements.
Audit reports
 Either of these situations prevents the auditor from expressing an opinion on
the financial statements as a whole. 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 the factors beyond the control of the client or the auditors,
rather than by restrictions imposed by the client.
 A disclaimer is distinguished from an adverse opinion in that it can arise only

from a lack of knowledge by the auditor, where as to express an adverse

opinion the auditor must have knowledge that the financial statements are not
fairly stated.
 When the auditor expresses a disclaimer of opinion, he/she has to make sure

that the following conditions are met: 

 An introductory paragraph is modified

 The scope paragraph is omitted-since the auditor does not undertake auditing.

 An explanatory paragraph is included after introductory paragraph

 A third paragraph contains a denial of opinion.

Discussion

1. Auditing has been claimed by many as a

profession which is more responsible to the public
than any other professions. Describe the elements
of a profession and explain why auditing is more
responsible to the public
2. List out the Auditing standards governing auditors
(Make a group of four, discuss and present the
results of your group discussion to the class
(Time allowed for discussion 10 min.
Sample Disclaimer reports.docx
 Sample Disclaimer Audit reports.docx

End of Chapter 2