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Chapter One
Overview of Audit

1.1 The nature, purpose and scope of audit

According to the International Standards on Auditing [ISA] 200 Objectives and General
Principles Governing an Audit of financial Statements, the objective of an audit is “to enable
the auditor to express an opinion whether the financial statements are prepared, in all material
respects, in accordance with an identified financial reporting frame work. The frame work
might be International Accounting Standards, or national standards of a particular country. The
phrases used to express the auditor’s opinion are that the financial statements ‘give a true and
fair view’ or present fairly in all material respects’.

The financial statements include balance sheet, income statement, statements of changes in
financial position [cash flows statement], note to the financial statements. What is included and
what is excluded in the audited financial statements is determined largely by national
legislations and accounting standards.

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

The Need for Audits of Financial Statements

Organizations achieve their goals through the use of human and economic resources. Most
often, economic resources are entrusted to the organization by groups or individuals outside it;
frequently these outsiders are quite remote from internal operations. Thus, organizations must
issue stewardship reports on resource administration – source, quantity, allocation,
accumulation, and depletion. These reportes are prepared and issued by the management.
Therefore, there could be a conflict of interest that may be reflected on these reports.

The primary reason for an independent audit is theinherent potential conflict between the
entity’s managent and users of its financial statements. Management could have an incentive
to bias theinformation preseted in financial statements because financial statements are one of
the means used to evaluate management’s performance. In general, demand for audit could be
identified as follows:

• Audit serves as important control mechanisms for accountability in using economic

resources.
• Audit serves as a wayout to objectively evaluate the performance of management as it
is expected to be objective and no conflict of interest.
• Audti serves as a second means to control or influence the possible harmful
consequence that may result using financial statements.

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• The volumness and complexty in content and preparation of financial statemtns

required an expert to verify and interpret these statements.
• Auditing bridges the gap that exists between the users of financial statements and actual
events that contribute for financial transactions. These are remote to the users of the
information.
• Audit fulfills the regulartory requirements.

1.2 Definitions and terminology

Auditing:

Broadly speaking, auditing is an independent investigation of some particular activity.

Although auditing has a precise meaning only when used with a limiting modifier, such as tax
auditing or financial auditing, one general definition of the term is as follows:

A systematic process of objectively obtaining and evaluating evidence regarding assertions

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

The important parts of this definition are:

• Systematic process: audts are structured activities that follow a logical sequence.
• Objectivity: this is the quality of the way that information is obtained and also a quality
of the person doing the audit. Essentially it means freedom from bias.
• Obtaining and evaluating evidence: this is a matter of examining the underlying
support for assertions or representations.
• Assertions about economic actions and events: this is a broad description of the
subject matter that is audited. An assertion is essentially a proposition that can be
proven or disproven.
• Degree of correspondence ... established criteria: this means an audit establishes the
conformity of assertions with specific criteria.
• Comminicating results: to be useful the results of the audit need to be communicated
to interested parties orally or in written.

Accounting:

Accounting is a process of financial data into financial summary of an economic entity reported
through financial satetments. In this regard, accounting can be consisered as constructive
process.

Accountancy:

Accountancy is a generic term used to encompass all accounting field of study such as book
keeping, financial accounting, management accounting, and auditing.

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Public Accounting:

Public accounting is a term that has come to represent accounting and auditing services and
other related services performed by a professionally qualified independent accountant
designated as a certified or chartered public accountant. The serives provided could include
auditing, accounting system design, management accountancy, and tax services.

1.3 Types of audits and auditors

1.3.1 Types of Audits

The type of audits depends up on the objective to be met through the audit. The major groups
of audit are internal audits and external audits. External auditing refers to objective examination
performed by a professionally qualified person who is engaged as an independent contractor
external to the organization to give an independent opinion. Internal auditing refers to the
managerial control activity performed within an organization as a service to management by
an employee of the organization. It involves a review of operations through the measurement
and evaluation of other control mechanisms, and assessment of the extent of their compliance.
Other form of audit service can be identified as Financial, Operational, and Compliance.

1.3.1.1 Financial Statement Audits

Financial audits deal with determining the fairness of accounting or financial information
(management assertions) based on conformity with Accepted Accounting Principles/Practices
(E.g. GAAP, IAS, Local Standards, common local practices) (the established criterion). The
most prevalent type of financial audit is the one performed by an outside accounting firm on
an organization's financial statements and which results in the accounting firm issuing a
standardized audit opinion in the annual report.

In performing the financial audits, the auditor may perform two types of tests: Account Balance
(substantive) tests and Control tests. The first testing deals with verifying the accuracy of an
account balance. The latter is concerned with the existence and functioning of controls in order
to reduce the amount of substantive testing. The objective of the control test is to determine
whether the control is functioning and not whether the control is the best one possible.

Financial audits are relatively straightforward and simple affairs when compared to other types
of audits. Financial audits are valuable to investors and other financial statement users because
the external accountant does not have a material financial interest in the company being
audited.

1.3.1.2 Operational Audits

Operational Audits seek to determine whether an organization's operations are being run
efficiently and effectively. It takes a stretch to come up with an explicitly stated management

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assertion concerning operational audits other than a general implicit understanding that
management through its goals and objectives is effectively and efficiently carrying out its
business. Likewise, it is difficult to identify established criterion for operational audits. About
the only criterion to be used is good business common sense. Operational audits are much less
structured and more customized for each individual audit than financial audits.

The "typical" operational audit engagement may include a comprehensive review of an entire
organization or merely limited to determining whether the controls in place are the most
efficient and effective controls possible.

The value of operational audits lie in the large amount of savings they can generate in terms of
reduced costs or better-directed operations. For this reason, most progressive organizations
have an active operational auditing function.

1.3.1.3 Compliance Audits

Compliance audits determines whether an organization is in compliance with government laws

and regulations, contracts, or its own policies and procedures. Organizations face a nearly
impossible task of complying with a bewildering array of laws and regulations. Auditors can
help by reviewing the organization's compliance with laws and regulations to enable the
organization to deal with any instances of non-compliance before they become a major
problem.

Environmental auditing or reviewing an organization's compliance with environmental laws

and regulations has become an important specialty in recent years. The Institute of Internal
Auditors recently started a separate certification in this area. See the IIA web site
http://www.theiia.org

The second type of compliance audits entails checking an organization's compliance with a
contract. More often this involves a construction project and hence the term "Construction
Audit" or "Construction Auditor." Construction audits are important for companies that have
large capital outlays for plant and equipment (for example an electric utility company).
However, contract audits are also becoming more important for companies that outsource
significant portions of their operations. Contract audits are valuable to organizations because
they can result in the identification of significant cash recoveries from contractors.

The final type of compliance audits involves the determination if company policies and
procedures are being followed. This is more along the lines of a traffic cop than auditing and
is not viewed too highly by progressive organizations. Auditees do not generally like auditors
when they perform these types of audits although they are essential where compliance with
operating procedures is very important, for instance from a safety perspective.

In summary, of the three types of audits, operational, compliance with laws and regulations
and compliance with contracts are probably the one most valued by managers, and financial

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audits by users of financial statements. For internal auditors, this means that their organization
should be performing more operational, compliance with laws and regulations and with
contracts audits, and less financial and compliance with company policies and procedures
audits.

1.3.2 Types of Auditors

Auditors can be classified according to their employment status.

External auditors (Certified Public Accountants, Chartered Certified Accountants) are third
party contractors more often hired by an organization to perform a financial audit of the
organization’s financial statements. Commonly referred to as independent auditors (in the
sense they have no financial interest in the organizations they audit).

Internal auditors on the other hand are employees of the organization in which they work.
Their independence is derived from their organizational status in terms of the official they
report to.

Traditionally, external auditors performed the financial audit and the internal auditors did the
operational and compliance audits. However, the clear distinction in duties between internal
and external auditors has become blurred as more and more internal auditing departments have
been outsourced.

Government auditors Staffs to perform audit function for the government. The extent and
scope of the audit performed are determined by legislation in various jurisdictions.

1.4 Auditing standards and principles

Standards are rules approved and adopted by various individuals and organizations. Standards
relating to the accouniting profession concerns both the professional qualities and judgements
exercised by professionals in the performance of their perofessional engagements.

Standards can be developed and become authoritative locally or internationally. The American
has the ‘Generally Accepted Auditing Styandards [GAAS], the international authoritative body
has International Standards on Auditng [ISAs]. Standards will be come authoritative after a
thorough deliberation on them.

Internationa Standards on Auditing [ISAs] are issued by the International Auditing Practics
committee [IAPC]. The IAPC is a standing committee of the Council of the International
Federation of Accountnats [IFAC], which was formed in 1977 and is based in New York. IFAC
has more than 140 member bodies, representing over 2 million accountants in 103 countries
and membership of IFAC authomatically cofers membership of the International Accounting
Standards Committee [IASC] base in London. The two organizations are independent of each
other, the former deals with auditing, the latter with accounting. The other standing committees

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of IFAC deal with ethics, education, financial and management accounting, the public sector,
information technology and membership

The IAPC issues standards and statements on auditing and related services in order to improve
the degree of uniformity of auditing practices and related services throughout the world. The
IAPC works closely with its memebers and natrional standard setters in order to gain
acceptance of ISAs. It expects its memebers to have due regard for ISAs insetting national
standards. Member bodies have increasingly sought to align the national position with the
international position as IFAC and the IASC have gained influence and recognition. Standard
setters increasingly refer to the international position in their consultative documents as
authoritative support for a particular view. The legislation enacted over the last ten years in
developing regions such as Central and Eastern europe, the former CIS, /africa and Pacific
Rim, has been developed to conform with international standards in order to attract inward
investment, and partially to avoid being seen to adopt the [politically unacceptable] US
position.

International auditing and accounting standards do not of course override local regulations.
Neither IFAC nor the IASC can compel any organization to comply with international
standards nor are ther specific sanctions where organizations claim to have complied with
international standards but have not done so.

1.5 Historical Evolution and Development of Auditing

the literature on auditing traces historical origionsof auditing to 500 – 300 B.C. to Greece where
the ciy of Athens was auditied be State Board of Auditors, indicating to us theat auditing was
performed in municipal administration [Wallace 1980].

The exact origin of of audits of financial reports is in dispute, but is is known that as early as
the fifteen century auditors were caaled on to ensure the absence of fraud in the records kept
by stewards of wealthy household estates in England. Although its origins are ancient,
devel;oppment of the audit function has occured most rapidly in the last century.

The evolution of conduct of audit could be traced through five stages of focus or orientation.
• Detection of fraud
• Third party relevance evidence
• Internal evidence and internal control
• Attest function emphasis
• Disclosure requirement

Each of the above focus and orientation have contributed to the development of field of audit
and delineation of the various types of audits by trying to answer the what, why, who, where,
and how of auditing.

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