WOLDIYA UNIVERSITY

FACULTY OF BUSINESS & ECONOMICS

DEPARTMENT OF ACCOUNTING
Auditing I (Acct 431)

Course Title: Auditing I

Course Code: Acct 431
Credit Hours : 3
Academic Year 2006
Semester: I
Instructor: Abdul-Aziz .K
Course Objectives
Upon completion of this course, the student will be able to:
 Understand the purpose and scope of auditing
 Identify and differentiate the types of audits and auditors
 Understand and appreciate code of professional conducts for auditors
 Describe auditing principles and tools
 Describe the basics of internal control
 Differentiate internal auditing from external audit
 Distinguish the different types of audit reports, their parts, and the accompanying
audit opinion
 Discuss about fraud in auditing
Course Description
This course is designed in such a way that student can be able to explore the underlying
theories, procedures and practices surrounding auditor’s responsibilities in examining and
reporting about financial statements of business enterprises. The course basically deals with
the way how evidences are collected so as to be used in the process of evaluating whether or
not financial statements present fairly the financial position, operational result and cash flows
of the company. Moreover, the course also deals with the process of collecting and
evaluating evidences to determine whether business enterprise safeguards assets, maintain
data integrity, achieves organizational goals effectively and consumes resources efficiently.

Course Content

Chapter I: Introduction 7hrs

1.1.            Historical evolution and development of auditing

1.2.            Definitions and terminology
1.3 Difference between Auditing and Accounting
1. 4. The nature, purpose and scope of audit
1.5.            Types of audits and auditors

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Chapter II: The Auditing Profession 7hrs

2.1.            Professional ethics

2.2.            Characteristics of a profession
2.3.            Rules of professional conduct
2.4.            Due care (Skill, diligence and expeditiousness)
2.5.            Independence, objectivity and integrity
2.6.            The professional duty of confidentiality
2.7.            Legal liability and responsibility
2.8.            Truth and fairness
2.9.            Materiality and the auditor
2.10.        Appointment, remuneration and removal of auditors
2.11.        Client acceptance procedures
2.12.        Engagement letters
2.13 proclamations related to auditors liability to
Chapter III: Auditing Principles and Tools 8hrs
3.1.            Auditing principles and standards
3.2.            Auditing procedures and techniques
3.3.            Audit approaches
3.4.            Financial statement assertions
3.5.            Audit objectives
3.6.            Audit planning
3.7.            Audit program
3.8.            Audit working papers
3.9.            Reliance on the work of others in audit

Chapter IV: Internal Control 7hr

4.1.            Definition
4.2.            Principles and elements of internal control system
4.3.            Internal control and external audits
4.4.            Internal control on revenues and purchases
4.5.            Internal control on payroll, cash and other areas; Report to management
4.6.            Internal auditing

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Chapter V: Audit Report 8hrs

5.1.            Types of audit reports

5.2.            Part of audit reports
5.3.            Audit opinion
5.4.            The standard unqualified audit report
5.5.            Departure from standard unqualified audit report
5.6.            International auditing and reporting guidelines
Chapter VI: Audit Evidence
Nature of Evidence
Audit Evidence decision
Persuasiveness of Evidence
Types of Audit Evidence
Types of analytical procedure
References
Text
 Arens & Loebbecke, Auditing, An Integrated Approach 7th ed. Prentice Hall Int’l:

 Konrath, Larry, Auditing Concepts & Applications: A Risk Analysis Approach, 4th
ed. South western College USA, 1999

 Guy, Dan M. etal, Auditing, 4th ed. The Dryden Press, Florida
 Meigs, Whittinton, Peny and Meigs, Principles of Auditing, 9th ed. Irwin Publishing
 co.1989 USA.
 David N.Richiute, Auditing Concepts and Standards. South -Western Publishing
co.1982 USA.
 Willingtom and Carmichael, Auditing Concepts and Methods. 2nd ed. 1975 USA.    
 Whittington & Pany, Principles of Auditing, 11th edition, Irwin, 1995
 Shekhar, Auditing, Vikas Publishing House, 2003

 Walter B. Meigs & etal., Principles of Auditing, 9th edition, 1989

 Johannes Kinfu, Auditing-Introduction to Principles and Practices, FBE, AAU
 D.R. Carmichael & etal, Auditing Concepts and Methods, 5th edition, 1989
 Alvin A. Arens & etal., Auditing an Integrated Approach, 5th edition, 1991
 ACCA Text Books on Audit Framework and Audit Assurance and Internal
Review
 You are encouraged to read any Auditing text or material

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JOURNALS, PERIODICALS AND MAGAZINES

1. Journal of Accounting Research, University of Chicago

2. Journal of accountancy AICPA edition
3. Interned auditing, Warren, Grham, & Lammont Publication
4. The Accounting Review
5. The Ethiopian Journal of Auditing and Accountancy
6. Journal on Accounting and Public Policy

Various Proclamations, orders and other legal provisions that affects Accounting and
auditing practices in Ethiopia

Evaluation Policy
Assignments, quizzes & tests……………… 20%
  Mid-term exam…………………………….. 30%

       Final exam…………………………………..50%

Total……………………………………….. 100%

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 UNIT ONE
INTRODUCTION TO AUDITING
1.1. Historical Development and Evolution of Auditing
The development of auditing is closely related, to the development of organized systems of
accounting. In the early stages of civilization, the number of transactions was usually so
small that an individual was able to record the transactions himself/herself. However, with
the growth of civilization and consequential growth in volume and complexities of
transactions, it became necessary to entrust the job of recording the transactions to other
persons. The trend started with the maintenance of accounts of empires by public officials.
Almost simultaneously, a need was felt to institute a check on the fidelity of the persons
responsible for retaining the accounts. To accomplish this purpose, it became customary to
entrust a person with the responsibility to hear those who had maintained the accounts. In
the course of time, such persons came to be known as auditors-the term being derived from
the Latin word 'audre,' which means to 'hear'.
The available evidence indicates that a system of auditing existed even in times of ancient
civilizations. Mesopotamian relics of commercial transactions reveal tiny marks, dots, ticks,
and circles at the side of the figures. This indicates that those figures had been checked. In
ancient Egypt, two officials recorded fiscal receipts separately and other officials conducted
the audit. In Greece, the accounts of public officials were scrutinized at the expiring of their
terms of office. In the UK during the 12th century records revealed the existence of a system
of accounting and auditing of the transactions of the state. Special audit officers were
appointed at the time to ensure that the revenue and expenditure of the state were duly
accounted for. The audit of the accounting system of London towards the end of the 13 th
century was aimed at ensuring the absence of frauds, arithmetical accuracy of accounts and
compliance with the authority given to the custodian. The subsequent years witnessed the
gradual maintenance of accounts by individual agriculturists, estate owners, traders and
others. Mercantile account took definite plan in Europe during this period. Contemporarily
the legal provisions and growth of the current auditing scene have immeasurably enhanced to
understand its earlier origins and the economical situation.
The development of trade and commerce between medieval Italian cities and the east, which
fostered the sailing ships "joint venture" accounts to end the venture at the completion of the
voyage. Thus, responsibility for this function fell on the shoulder of the bookkeeper and the
lawyer. These events were further evolved by the growth of partnership and credit trade and
commerce. During the 1500s the practice of outside verification spread to the rapidly
developing limited liability companies (LLC) who were responsible for outside investors.
In a parallel development, English manorial auditing began during the medieval period when
records of large manors (farms) were reviewed annually by auditors who represented the lord
and the council. This became the foundation of the British statutory audit in the 19 th century
and later spread throughout Europe.
It is, however, the Industrial Revolution (1900) that the accentuated the need for the
verification of appropriate allocation of labor wages and proper determination of profits to
assess what is to be partaken by labour, government and owner.
This was the period where government regulation of business taxation and banking
regulation of business, and development in economic theory come to influence thoughts on
business, costs, and finance requiring more appropriate determination and evaluation of net
income, and valuation of balance sheet.

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First, a voluntary company audit was instituted in to practice where companies were having
their accounts voluntarily audited. Then, in 1844 company audited by persons independent of
management become a requirement by law. Considerations of labor disputes, changes in
technology development in large scale enterprise (railways), and changes in economic
thought, emerging government regulatory bodies, income taxation and corporate entity
concept were influencing events preceding the stock market crash, all of which gave
prominence to financial control and accountability.
The stock market crash debacle in 1930 registered the establishment of the SEC, and the need
for investigation into false companies accompanied by new requirements on audits. Auditors'
responsibility in fraud detection was viewed in new perspective. The auditors' legal liability
and responsibility for third party, reliance and evidence was being affirmed through common
law.
By 1940, interest in internal management efficiency and performance, and the need of
information for planning and decision making brought the development of management
accounting and internal control. This event directed focus of development in internal audit. In
the 1950s and 60s system based approach to audit come to gain grounds and a new view on
attest function forged which stressed on disclosure requirement and social responsibility of
the auditor.
In the 1990s, risk based approach obtained wide acceptance and application in the auditing
practice. Area of focus is by risk weight. Risk assumed are guided by level of assurance
needed to obtain evidence and concomitant cost. Thus, the higher the risk objects, the more
intensive the audit is.
In general, these 20th century developments in auditing may be helpful to you in
understanding the direction in which auditing is moving. Among them, the most significant
developments are:
a) A shift in emphasis from the detection of fraud to the determination of fairness of
financial statements.
b) Increased responsibility of the auditors to third parties, such as governmental agencies,
stock exchanges and an investing public.
c) The change of auditing method from detailed examination of individual transaction, to
the use of sampling techniques, including statistical sampling.
d) Recognition of the need to consider internal control as a guide to the direction and
amount of testing and sampling to be preformed.
e) Development of new auditing procedures applicable to electronic data processing systems
and use of the computer as an auditing tool.
f) Recognition of the need for auditors to find means of protection from the current wave of
litigation
g) An increased demand for prompt disclosure of both favorable and unfavorable
information concerning any publicly owned company.
h) Increased concern with compliance by organizations with laws and regulations.

1.2. Definitions and Terminologies of Auditing

You might have heard of the terms 'Auditing' and 'auditors' many times. What is your knowledge
of the meaning of these terms? What in your understanding does auditor do? When such
questions are put to a group of people the replies would be quite different. Different people have
defined auditing in different ways. Most of these definitions give importance only to some
aspects of auditing. In some cases interestingly some would reply that an auditor is a person who
checks the accounts and always finds fault with what has been done. Some others say that
auditing is a process through which frauds and errors are detected. One would say that an auditor
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is a person who checks the correctness of accounts of an enterprise before they were made public.
Most of these definitions give importance only to some aspects of auditing. Let us, however,
begin our discussion on the nature of auditing by the following definitions, which explain
auditing in a comprehensive manner.
a)In its modern sense, an audit is defined as a process carried out by suitably qualified
auditors where by the accounting records of the business entity are subject to scrutiny in such
due as will enable the auditors to form an opinion as to their truth, fairness and accuracy.
b) Auditing is also described as a process of collection and evaluation of evidence for the
purpose of reporting on economic information.
The definitions of auditing above, states that the purpose of auditing is "reporting" by
auditors about economic information. The auditors report is the end result of the audit
process. The auditors report can be of different kinds. In the case of an audit of balance sheet
and profit or loss account of an enterprise, the auditor expresses his/her opinion on reviewed
financial statement whether the accounts show a true and fair view of the financial position
and financial performance. The nature and scope of the auditor's report in a particular case
depends primary on the terms of engagement and the provision of applicable laws.

c)The institute of chartered accountants of India has defined auditing as "a systematic
independent examination of data, statements, records, operations and performances of an
enterprise for a stated purpose. In any auditing situation the auditor recognize propositions
before he/she programs for examination, collects evidence, evaluates the data and on this
basis formulates his/her judgment which is communicated through his/her audit report.
d)According to Arens and Loebbecke, auditing is defined as, 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 independent person.
The description of auditing by Arens and Loebbecke includes several key terminologies
which are discussed in this section briefly.
 Information and established criteria: To do an audit, there must be information in a
verifiable form and some standards [criteria] by which the auditor can evaluate the
information. Information can and does take many forms. Auditors routinely perform
audits of quantifiable information, including companies’ financial statements and
individuals’ federal income tax returns. Auditors also perform audits of more subjective
information, such as the effectiveness of computer systems and the efficiency of
manufacturing operations. The criteria for evaluating information also vary depending on
the information being audited.
 Accumulating and evaluating evidence: Evidence is defined as any information used by
the auditor to determine whether the information being audited is in accordance with the
established criteria. Evidence takes many different forms, including oral testimony of the
auditee, written communication with outsiders, and observations by the auditor. It is
important to obtain a sufficient quality and volume of evidence to satisfy the purpose of
the audit.
 Competent, independent person: The auditor must be qualified to understand the criteria
used and competent to know the types and amount of evidence to accumulate to reach the
proper conclusion after the evidence has been examined. The auditor also must have an
independent mental attitude. It does little good to have competent person who is biased
performing the evidence accumulation when unbiased information and objective thinking
are needed for the judgments and decisions to be made.
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 Reporting: The final stage in the audit process is the audit report, which is the
communication of the findings to users. Reports differ in nature, but in all cases they
must inform readers of the degree of correspondence between information and
established criteria. Reports also differ in form and can vary from the highly technical
type report usually associated with financial statement audits to a simple oral report in the
case of an operational audit done of a small department’s effectiveness.
1.3. Difference Between Auditing and Accounting
Accounting is the recording, classifying and summarizing economic events in logical manner
for the purpose of providing information for decision making. The function of accounting is
to provide certain types of quantitative information that management and other can use to
make decision. To provide relevant information, accountant must have through
understanding of the principles and rules that provide base for preparing accounting
information. In addition accountant must develop a system to make sure that the activities,
economic events are properly recorded on timely basis at reasonable cost.
In auditing the accounting data, the concern is with determining whether the recorded
information properly reflects the economic events that occur during the accounting period.
Since the accounting rules are the criteria for evaluating whether the information is properly
recorded, any auditor involved with those data must thoroughly understand these rules that
govern the accountancy.
The difference between auditing and accounting is best summarized as follows:
Accounting Auditing of financial statement
 Is the process of  Is the process of obtaining and evaluating
identifying ,measuring, recording and evidences and determining the fairness of
communicating economic financial statement inconformity with
information about an organization in GAAS
conformity with GAAP
 Deliver financial statements to users  Deliver audit report(opinion) to users
 precede auditing  Begins when accounting ends
 No prescribed qualification is legally  The external auditor must be chartered
required for the accountant accountant(CPA)
 All accountant may not have auditing  Auditors must have accounting
knowledge knowledge
 An accountant is an employee of the  An auditor is independent professional
firm
 Constructive and theoretical  Critical aspect of accounting and
analytical in nature
 Generally appointed by management  Appointed by the shareholders or audit
and expected to perform according to committee of the organization and is
the rule and regulation set by independent
management

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1.4. Nature, Purpose and Scope of Auditing
1.4.1. Nature of Auditing
Framework of Auditing and Assurance Standards and Guidance Notes on Related service
issued recently distinguishes audits from related services. Related services comprise reviews,
agreed-upon procedures and compilations. Audits and reviews are designed to enable the
auditor to provide high and moderate levels of assurance respectively, such terms being used
to indicate their comparative ranking.

Assurance in this context refers to the auditor's satisfaction as to the reliability of an assertion
being made by one party for use by another party. To provide such assurance, the auditor
assesses the evidence collected as a result of procedures conducted and expresses a
conclusion. The degree of satisfaction achieved and, therefore, the level of assurance which
may be provided is determined by the procedures performed and their results. In an audit
engagement, the auditor provides a high, but not absolute, level of assurance that the
information subject to audit is free of material misstatement expressed positively in the audit
report. In a review engagement, the auditor provides a moderate level of assurance that the
information subject to review is free of material misstatement. This is expressed in the form
of negative assurance. For agreed-upon procedures, auditor simply provides a report of the
factual findings, no assurance is expressed. Instead, users of the report draw their own
conclusions from the auditor's work. In a compilation engagement, although the users of the
compiled information derive some benefit from the involvement of a member of the Institute,
no assurance is expressed in the report. 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 framework "give a true and fair view".
Absolute assurance in auditing is not attainable as a result of such factors as the need for
judgment, the use of test checks, the inherent limitations of any accounting and internal
control systems and the fact that most of the evidence available to the auditor is persuasive,
rather than conclusive, in nature. The objective of a review of financial statements is to
enable an auditor to state whether, on the basis of procedures which do not provide all the
evidence that would be required in an audit, anything has come to the auditor's attention that
causes the auditor to believe that the financial statements are not prepared, in all material
respects, in accordance with an identified financial reporting framework. While a review
involves the application of audit skills and techniques and the gathering of evidence, it does
not ordinarily involve on assessment of accounting and internal control systems, tests of
records and of responses to inquiries by obtaining corroborating evidence through inspection,
observation, confirmation and computation, the auditor attempts to become aware of all
significant matters, the procedures of a review make the achievement less likely than in an
audit engagement, thus the level of assurance provided in a review report is correspondingly
less than that given in an audit report. In an engagement to perform agreed-upon procedures
and auditor is engaged to carry out those procedures of an audit nature to which the auditor
and the entity and any appropriate third parties have agreed and to report on factual findings.
The report is restricted to those parties that have agreed to the procedures to be performed
since others, unaware of the reasons for the procedures, may misinterpret the results. In a
compilation engagement, a member of the Institute is engaged to use accounting expertise as
opposed to auditing expertise to collect, classify, and summaries financial information. The
procedures employed are not designed and do not enable the member to express any
assurance on the financial information. However, users derive some benefit as a result of the
member's involvement because the service has been performed with due professional skill
and care. An auditor is associated with financial information when the auditor attaches a
report to that information or consents to the use of the auditor's name in a professional
9
connection. If the auditor is not associated in this manner, third parties can assume no
responsibility of the auditor.

1.4.2. Purposes of Auditing

Dependable financial information is essential to the very existence of the society. In making
a decision, such as, to buy or sell securities, the banker deciding to approve a loan; the
government to obtain revenue based on income tax returns etc, all are relying upon
information provided by auditors.
There are many advantages of auditing to the modern society. The more important of these
are as follows.
A. Tool of Control over Resources
The most advantage of auditing is that it acts as a tool of control over those who harm
resources belonging to others. In the case of government, audit seeks to ensure that the use
the public funds properly. Whenever a person or authority is entrusted with the resources
belonging to others, it becomes necessary to exercise suitable control over such people by
officials to ensure that the resources are used properly. Audit can act as an important
instruction of practicing such control. Experiences of certain countries show that whenever
the audit becomes weak, there was a gross misuse of public funds. Thus, audit acts as a mere
protection against misuse of funds and reduces the possibility of errors and frauds.
B. Tool for Enhancing Creditability of Economic Information
Another advantage of auditing is that it enhances the credibility of economic information, thus, the
shareholders of a company would give greater reliance on the financial statements of the
company, if the auditor expresses the opinion that these statements present a true and fair view.
Apart from the owners, other readers of financial statements of an enterprise also place great
reliance on them if they have been audited.
C. Tool for Improving Economy and Efficiency
During examination of any type of audit, the auditor reviews the activities of the enterprise.
He/she is, therefore, often in a position to make suggestions to improve the efficiency of
various activities of the enterprise. Certain types of audits are carried on to review the
operations and activities, so that, wastages and losses can be minimized, weaknesses in the
system can be discovered and overcome, and control can be strengthened. In internal audit
of operational audit or management audit the auditor generally makes proposals for
improving the economy and efficiency within which resources are employed.
The need for most types of audit arises only after the accounting process is completed. The
auditor conducts the final product of the accounting system and attempts to collect evidence
to enable him/her to express an opinion thereon. Therefore, in most audits, the auditors
review the completed work of an accountant from a specific outlook. Auditor's task begins
where the task of the accountant ends. The auditor should reasonably assure himself/herself
that the accounting system is adequate and that all the accounting information that should be
recorded has in fact been recorded.
The auditor should gain an understanding of the accounting system and related internal controls
and should study and evaluate the operation of those internal controls upon which he wishes to
help in determining the nature, timing and extent of other audit procedures.
Upon completing the review and testing of the accounting records, the auditors should
prepare a working paper describing the records in use, the tests of controls and other audit
procedures followed, the nature and significant misstatements discovered, any suggestions
for improving the accounting system and the auditors conclusion as to the overall quality of
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accounting records. This working paper summarizes an important part of the auditor's
consideration of internal control and may serve as a reference for determining appropriate
modifications in the audit program. At the beginning of the next annual audit, a review of
the working paper will enable the auditors to concentrate up on the most significant aspects
of the accounting records.
1.4.3. Scope of Auditing
The scope of auditing depends on the type of auditing performed by the professional
auditors. Hence the scope of internal and external auditing is described as follows.
The scope of internal audit activity includes examining and evaluating the policies,
procedures and systems which are in place to ensure: reliability and integrity of information,
compliance with policies, plans, procedures, laws and regulations; safeguarding assets;
economical and efficient use of resources; and accomplishment of established objectives and
goals for operations or programs. Internal Audit may provide consulting services within the
organization concerning issues related to internal controls, special investigations, and other
areas of interest and concern. Whereas, external audit is aimed at caring out such work as is
necessary to form an opinion as to whether:
a) The accounts are properly kept; and
b) The annual financial statements:
i) are prepared in accordance with the financial records; and
ii) Represent fairly the results of the operations and the financial in accordance with
the Accounting Standards, relevant legislation and other mandatory professional reporting
requirements. The auditor is to include in their proposal the extent to which the critical
matters such as revenue, expenditure, assets liabilities and equities will be audited to provide
reasonable assurance of whether these items are free of material misstatement caused either
by fraud or error. The scope of governmental auditing is to provide reasonable assurance of
whether the rules regulations and all the proclamations issued by the government is being
respected by the client.

1.5. Types of Auditors and Auditing

1.5.1. Types of Audits
Audits are often classified in to three major types:
1) Audit of Financial Statement
2) Compliance Audit
3) Operational Audits /Performance Audits/
1. Audit of Financial Statement
Audit of financial statements is actually part of the broader concept of the attest function. To
attest to information mean to provide assurance as to fairness or dependability. Certified
Public Accountants (CPAs) attest to a host of other types of information including the
reasonableness of financial forecasts, the adequacy of internal control and compliance with
laws and regulations. To attest to financial statements is to provide assurance as to their
fairness and dependability. The attest function consists of two phases. The first is the
performance of an audit; the second is the issuance of an audit report. The attest function
leads to credibility to management's representations that are contained in the financial
statements.
The audit of financial statements ordinarily covers the balance sheet and the related
statements of profit and loss and cash flows. Financial audit generally is conducted to
ascertain whether the financial statements present true and fair views of the financial position
and working results of an enterprise or organization. The goals of audit of financial
statements are to determine whether the statements have been prepared in conformity with
generally accepted accounting principles. The aim of an independent financial audit is to
11
ascertain if the financial statements of an enterprise are reliable and dependable. Financial
statements audits are normally performed by certified public accountants. The contribution of
the independent financial audit is to give credibility to financial statements. Credibility, in
this usage means that the financial statements can be believed that is, they can be relied upon
by outsiders, such as stockholders, creditors, government and other interested third parties.
The word “audited” when applied to financial statements means that balance sheet, profit and
loss statements and cash flows are accompanied by an audit report prepared by independent
auditors expressing their professional opinion as to fairness of the enterprise's financial
statements. Financial statements prepared by management and released to outsiders without
first being audited by independent auditors leave a credibility gap.
The Objectives of Audit of Financial Statement are:
 To determine whether financial statements have been prepared in accordance to the
generally accepted accounting principles.
 To ensure the completeness of financial statements.
 To vouch the existence of recorded transactions in the financial statements.
 To examine the accuracy of the financial statements.
 To ensure that the net income / loss is the result of the operation for a given accounting
period.
 To verify availability of assets recorded in the balance sheet.
2. Compliance Audit
The performance of a compliance audit is dependent upon the existence of verifiable data and
of recognized criteria or standard established by an authoritative body. Such audits seek to
determine whether a tax collection is in compliance with tax laws and regulations.
Compliance audit is defined, as an audit to determine whether verifiable data such as income
tax returns or other financial statements are in conformity with established criteria, for
example, laws and regulations, society has always been concerned with compliance with
laws and regulations by all types of entities, business, government and non profit making
organizations. Legislative public officials and the general public want assurance about
compliance. Many governmental entities and non-profit making organizations that receive
financial assistance from banks are subject to periodic compliance audit. Such audits are
designed to determine whether the financial assistance is spent in accordance with applicable
laws and regulations.
In auditing the financial statements of the governmental and non-governmental organizations, the
auditor must often perform tests of compliance with laws and regulations to determine that
violations do not have a direct and material effect on financial statements.
The Objectives of Compliance Audits are:
 To determine whether there have been violations of laws and regulations that may have a
material effect on the organizations financial statements.
 To provide a basis for additional reports on compliance procedures that is not tests of the
internal control policies and procedures. Compliance procedure is defined, as performing
procedures to act with laws and regulations.
The auditors may discover violations of provisions of laws, regulations, contracts or grants
that result in which they estimate to be material misstatement to the organization's financial
statements. Such violations are known as material instances of non-compliance. Non-
compliance is the failure to act in accordance with laws or regulations. In these
circumstances, the auditors must consider the effect on their opinion issues on the financial
statements. The resulting misstatement, if left uncorrected, would normally require the
auditors to issue a qualified or adverse opinion. The auditors may also report a description or
any indications of illegal acts that could result in criminal prosecution.

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3. Operational audits /Performance Audits/
An operation audit is a systematic independent appraisal activity within an enterprise for a
review of the entire departmental performance as a service to management. The overall
objective of operational auditing is to assist all levels of management in the effective
discharges of responsibilities by furnishing them with objective analysis, appraisal,
recommendations and pertinent comments concerning the activities reviewed. It may be
noted that the terms, operation audit and performance audit often are used interchangeably.
The purpose of an operational audit usually includes the intention to appraise performance of
a particular organizational function or group activities. However, the broad statement must
be expanded to specify precisely the scope of the audit and the nature of the report. The
auditors must determine specifically which policies and procedures are to be appraised and
show their relation to the specific objectives of the enterprise or organization.
Before starting the operational audit, the auditors must obtain a comprehensive knowledge of
the objectives, organizational structure, and operating characteristics of the unit to be audited.
This familiarization process might begin with a study of organizational charts statements of
the function and responsibilities assigned are management polices and directives and
operating polices and procedures.
In attempting to meet, managerial needs, operational auditors sample the work performance to see
whether it is in accordance with approved procedures. They verify the accuracy and consistency
of the information obtained in operating reports, and they study the format of the reports to
determine whether the information is presented in a meaningful form. The auditor's responsibility
for seeing that the enterprise's assets are safeguarded against fraud is expanded to a responsibility
for providing protection against all kinds of waste. An enterprise having a strong system of
internal control over its cash, inventory, and other personal property will never suffer a serious
loss from fraud or theft.
Now-a-days economic pressures are forcing companies and government enterprises at all
levels to economize, resulting in an increased demand for the information provided by
operational audits. The demand has been so pronounced that operational auditing has become
an extension of the internal auditing function of most large enterprises. Also governmental
auditors engage extensively in evaluating the economy, effectiveness and efficiency of
various government programs.
Objectives of Operational Audits
Internal auditors often perform operational audits. The main users of operational audit
reports are managers at various levels including the board of directors. Decision makers
need assurances that every component of an enterprise is working to attain the organization's
goals. For example, the management needs the following information.
 Assessment of the unit performance in relation to management's objectives or other
appropriate criteria.
 Assurance that its plans are comprehensive, consistent and understood at the operating
levels.
 Objective information on how well its plans and policies are being carried out in al
areas of operation's and opportunities for improvement in effectiveness, efficiency and
economy.
 Information on weakness in operating controls, particularly as to possible sources of
waste.
 Reassurance that all operating reports can be relied on as basis for action.
In every audit, it is important to state clearly the boundaries of the examination. These
boundaries identify the economic entity to be examined and the time period to be covered.
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Thus, the boundaries serve to define and to limit the auditors' responsibilities. The economic
entity to be audited may be a sole proprietorship, a partnership, a corporation and its
subsidiaries.
1.5. Types of Auditors
Auditors are often viewed as falling into three main types
1. Independent financial auditor /Certified Public Accountant/
2. Internal auditors
3. government auditors
1. Independent financial auditor: Independent/financial auditor or certified public
accountant is a person licensed by the state to practice public accounting as a profession
based on having passed the uniform CPA examination and having met certain education
and experience.
Including public accounting profession, all of the recognized professions have many common
characteristics. The most important of these characteristics are a responsibility to serve the public,
of a complex knowledge, standards of admission to the profession and a need for public
confidence. To Certified Public Accountants, public confidence is of special significance.
Credibility is the product of the certified public accountants. Without public confidence in the
attester, the attest function serves no useful purpose. To attest to financial statements means to
provide assurance as to their fairness and dependability. The attest function includes, first, the
independent public accountant, must carry out an examination to provide the objective evidence
that enables the auditors to express an informed opinion on the financial statements. Second, the
attest function is the issuance of the auditor's report, which conveys to users of the financial
statements the auditor opinion as to the fairness and dependability of the financial statements.
Reliable financial information is essential to the very existence of society. Thus, good accounting
and audited financial statement aid society in allocation its resources in the most efficient manner.
The goal is to allocate limited resources to the production of those goods and services for which
demand is greatest. Economic resources tend to be attracted to the industries, and the
organizational entities that are shown by accounting measurements to be capable of using more
resources to the best advantage. Inadequate and inappropriate accounting result on the other hand,
conceal waste and inefficiency and thereby prevent resources from being allocated in a rational
manner. It is the report by the independent auditors that gives credibility to a set of financial
statements and makes acceptable to investors, bankers, government and other users.
2. Internal Auditors: Although most auditing literatures interest is primarily in the audit of
financial statements by Certified Public Accountants, other professional groups carry on
large scale auditing. These well known types of auditors are internal auditors.
The standard definition adapted by the Institute of Internal Auditors of United States of America,
however is that internal auditing is an independent appraisal activity established within an
organization or enterprise to examine and evaluate its activities as a service to the organization in
the effective discharge of their responsibilities by furnishing their analysis, appraisals,
recommendations and counsel. In performing these functions internal auditors can be considered
as a part of the organization's internal control structure. They represent high level control that
functions by measuring and evaluating the effectiveness of other internal control policies and
procedures.
Internal auditors are not merely concerned with the organization's financial controls. Their work
encompasses the entire internal control structure of the organization or enterprise. They evaluate
and test the effectiveness of internal control policies and procedures designed to help the
organization or enterprises to meet all of its objectives.

14
The internal auditing head often accordingly reports to the general manager or board of directors
or president or another high executive. This strategic placement high in the organizational
structure helps assure the internal auditors will have ready access to all units of the business and
that their recommendations will be given prompt attention by department heads. This reporting
standard provides guidance for the head of internal auditing in managing the internal auditing
functions. The head of internal auditing is responsible for properly managing the departments to
help assured that, the audit work is preformed in accordance with professional standards and
fulfills the general purposes and responsibilities developed by management of the organization
and the resources of the internal auditing department are efficiently and effectively employed.
A large part of the internal auditors consists of operational audits in addition; they may conduct
numerous compliance audits. The number and kind of investigative activities varies from year to
year. Unlike the certified public accountants who are committed to verify each significant item in
the annual financial statements the internal auditors are not obliged to repeat their audits in annual
basis.
3. Government Auditors: A government audit is conducted primarily to ensure that financial
transactions are recorded with proper sanction and authorization. In Ethiopia, the office of auditors
General and office of control has been given the responsibility to conduct the audit of the central
government and the state government. Government auditors examine and make that
 Transactions are correctly recorded and activities conform to the rules and regulations
 Ensure that public funds are not misused
 Examine the efficiency and effectiveness of selected projects or program run by
government.
To sum up, auditors and type of auditing area or audit emphasis are summarized as follows.
Audit Auditors
Internal auditors Independent Auditors Government
Auditors
Operational Primary Nominal Primary
Audit
Financial Audit Secondary Primary Nominal
Compliance Primary Secondary Primary
Audit

UNIT TWO
AUDITING PROFESSION

2.1. Profession
A profession is a vocation of the highest standing. It calls on its members to serve the public
by offering to them highly technical and always confidential advise and services, which
require a different standard of conduct from the tradesman. Its members stand in a different
relationship altogether from the man doing ordinary business….
Considered in this definition, most criteria for a profession include a requirement for a
professional code of conduct.
Characteristics of Profession
Profession may be defined from various perspectives but is expected to contain basic
elements regardless of whatever perspective it is defined.
 Encyclopedia of sociology sets five criterions for profession: esoteric knowledge,
autonomy on the job, authority over clients, altruistic and public recognition of the
occupation as a profession.

15
 On the other hand, concise Oxford Dictionary of sociology defines profession using four
criterions: central regulatory body, code of conduct, careful management of knowledge
and control on members in the profession.
 Encyclopedia of Education sets six criterion: an essential social function to be performed,
lengthy period of training and experience to enter the profession, practitioners are service
oriented (altruistic), official recognition of professional status by the government, the
nature of service rendered makes the clients incapable of appraising it and there are
standards of competence.
There seems to be a level of consensus on major factors in the definition of a profession.
Hence, a profession can satisfy be characterized by the following elements:
 Specialized body of knowledge,
 Standard of qualification for admission,
 Standard of conduct of behavior,
 Level of status recognition, and
 Acceptance of social responsibility and legal liability
Specialized Body of Knowledge
A highly developed profession has a very highly specialized written body of knowledge. The
more the profession is highly developed the more specialized the body of knowledge and,
requiring longer period of time to absorb. The body of knowledge is dynamic and is in
constant development and growth and not static. The body of knowledge here goes far
beyond general educational knowledge.
Standard of qualification of admission
A profession to be a profession must have well- recognized and accepted predetermined
criterion of qualification for admission in to the profession. The standards include
educational requirements as well as other normal and legal criteria fulfillment. The
educational requirements are, composed of theoretical knowledge and practical experience.
Usually, the fulfillment of these requirements is measured through tests of qualifying
examinations to prove the consumption of the accumulated body of knowledge that exists in
the profession, and competence in it.
Standard of Conduct of behavior
A profession has standard of conduct of behavior to be observed by the professional through
prescribed code of ethics that attempt to enforce general rule conduct, and maximum and
mini mum rules on competency and responsibility to client and colleagues. Good example of
such code of conduct is the "Oath of Hippocrates" which is sworn by medical doctors at their
graduation.
Level of status recognition
The quality and level of professional services demanded y society determines the level of
status and recognition to the profession. The level of status and recognition earned in a
society is a function of the quality f professional service rendered which in turn are a function
of standard of professional qualification and the degree of the social, moral and legal
responsibility assumed. The more rigorous are standard of qualification and cod of ethics
needed for rendering the professional services, the higher will be the level of status and
recognition given to the profession.
Acceptance of social responsibility and legal liability
A profession to be a Profession must accept responsibility for the consequences of its action.
Not only legal responsibility which arises out of the contractual obligation, but also moral
responsibility to the profession itself and the profession to the society at large. The profession

16
itself has responsibility to assure the society of the quality of services demanded and accept
sanction for failure to do so.
One can find these characteristics in different stages of growth and development in various
professions. Some profession more than others seem to have attempted to fulfill some
elements better. The roll of professional associations in this regard is crucial. An association
is a body of professional and it is this body that place important roll in prescribing the
professional standards and policing their implement ability.
1.2. Professional Ethics
Broadly defined, the term ethics represents the moral principles or values of conduct
recognized by an individual or group of individuals. Ethics apply when individual has to
make decision from various alternatives regarding moral principles. All societies and
individuals possess a sense of ethics in that they can identify what is "good" or "bad". As
C.S. Lewis Observed, "Human beings all over the earth have some sort of agreement as to
what right and wrong are."
Ethical conduct is determined by each individual. Each person uses moral reasoning to
decide whether some thing is ethical or not. Ethics are a moral code of conduct that requires
an obligation by us to consider not only ourselves but others. There are a number of ways
that individuals can receive ethical guidance in making moral decisions. Sources for ethical
guidance include our family, friends, religion, and role models.
The purpose of professional ethics in the auditing profession as well as in any other
profession is to build the public confidence, to judge the quality of audit work and means of
grounding guidance of conduct for practitioners.
The advantage of prescribing professional ethics is to emphasize positive activity and
encourage high level of performance while preventing mal-practices. However, there is
difficulty in concretizing them. First, they can only be prescribed in general terms to avoid
prescribing unacceptable behavior, and it's difficult to enforce general ideas of behavior.
Second it is difficult to interpret behavior with out reference to specific situation at which
point it requires interpretation of rulings according to circumstances. However, important
parts of ethics in auditing are in relation to:
 Maintenance of mental and physical independence
 General competence and technical standards
 Responsibility to client and colleagues and
 Other responsibilities and Practices that have bearing on ethical conduct include acts
discreditable to the profession, i.e. commission, incompatible occupation, soliciting etc.
These are best maintained by following some guidance called code of professional conduct

2.3. Rules of professional conduct (code of conduct)

Due to national differences of culture, language, legal and social systems, the task of
preparing detailed ethical requirements is primarily that of the member bodies in each
country concerned and that, they also have the responsibility to implement and enforce such
requirements.
However, the identity of the auditing profession is characterized worldwide by its endeavor
to achieve a number of common objectives and by its observance of certain fundamental
principles for that purpose. Therefore, recognizing the responsibilities of the auditing
profession as such, and considering its own role to be that of providing guidance,
encouraging continuity of efforts, and promoting harmonization, has deemed it essential to
establish an international Code of Ethics for Professional auditors to be the basis on which
the ethical requirements (code of ethics, detailed rules, guidelines, standards of conduct, etc.)
for professional auditors in each country should be founded.
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This international Code is intended to serve as a model on which to base national ethical
guidance. It sets standards of conduct for professional auditors and states the fundamental
principles that should be observed by them in order to achieve common objectives. Auditing
profession throughout the world operates in an environment with different cultures and
regulatory requirements. The basic intent of the Code, however, should always be respected.
It is also acknowledged that, in those instances where a national requirement is in conflict
with a provision in the Code, the national requirement would prevail.
Further, the Code is established on the basis that unless a limitation is specifically stated, the
objectives and fundamental principles are equally valid for all professional auditors, whether
they are in public practice, industry, commerce, the public sector or education.
Members’ duty to their profession and to society may at times seem to conflict with their
immediate self interest or their duty of loyalty to their employer. Against this background, it
is beholden on member bodies to lay down ethical requirements for their members to ensure
the highest quality of performance and to maintain public confidence in the profession.
These include:
The Public Interest
A distinguishing mark of a profession is acceptance of its responsibility to the public. The
auditing profession’s public consists of clients, credit grantors, governments, employers,
employees, investors, the business and financial community, and others who rely on the
objectivity and integrity of professional auditors to maintain the orderly functioning of
commerce. This reliance imposes a public interest responsibility on the auditing profession.
Auditor’s responsibility is not exclusively to satisfy the needs of an individual client or
employer. The standards of the auditing profession are heavily determined by the public
interest.
Auditors have an important role in society. Investors, creditors, employers and other sectors
of the business community, as well as the government and the public at large rely on auditors'
sound financial reporting, effective financial management and competent advice on a variety
of business and taxation matters. The attitude and behavior of auditors in providing such
services have an impact on the economic well-being of their community and country.
Auditors can remain in this advantageous position only by continuing to provide the public
with these unique services at a level which demonstrates that the public confidence is firmly
founded. It is in the best interest of the worldwide auditing profession to make known to
users of the services provided by them that they are executed at the highest level of
performance and in accordance with ethical requirements that strive to ensure such
performance.
In formulating their national code of ethics, member bodies should therefore consider the
public service and user expectations of the ethical standards of auditing profession and take
their views into account. By doing so, any existing “expectation gap” between the standards
expected and those prescribed can be addressed or explained.
Fundamental Principles
In order to achieve the objectives of auditing profession, auditors have to observe a number
of prerequisites or fundamental principles.
The fundamental principles are:
• Integrity: Auditors should be straightforward and honest in performing professional
services.
• Objectivity: Auditors should be fair and should not allow prejudice or bias, conflict of
interest or influence of others to override objectivity.
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• Professional Competence and Due Care: Auditors 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 developments in practice,
legislation and techniques.
• Confidentiality: Auditors should respect the confidentiality of information acquired during
the course of performing professional services and should not use or disclose any such
information without proper and specific authority or unless there is a legal or professional
right or duty to disclose it.
• Professional Behavior: Auditors must act in a manner consistent with the good reputation
of the profession and refrain from any conduct which might bring discredit to the profession.
• Technical Standards: Auditors should carry out professional services in accordance with
the relevant technical and professional standards.
Auditors have a duty to carry out with care and skill, the instructions of the client or
employer insofar as they are compatible with the requirements of integrity, objectivity and, in
the case of professional accountants in public practice. In addition, they should conform to
the technical and professional standards promulgated by:
 IFAC (e.g., International Standards on Auditing);
 International Accounting Standards Board;
 The member’s professional body or other regulatory body; and
 Relevant legislation.
Integrity and Objectivity
Integrity implies not merely honesty but fair dealing and truthfulness. The principle of
objectivity imposes the obligation on all professional accountants to be fair, intellectually
honest and free of conflicts of interest.

Auditors serve in many different capacities and should demonstrate their objectivity in
varying circumstances. They undertake assurance engagements, and render tax and other
management advisory services. As professional accountants, they prepare financial
statements as a subordinate of others, perform internal auditing services, and serve in
financial management capacities in industry, commerce, the public sector and education.
They also educate and train those who aspire to admission into the profession. Regardless of
service or capacity, auditors should protect the integrity of their professional services, and
maintain objectivity in their judgment.

In selecting the situations and practices to be specifically dealt within ethics requirements
relating to objectivity, adequate consideration should be given to the following factors:
 Auditors are exposed to situations which involve the possibility of pressures being
exerted on them. These pressures may impair their objectivity.
 It is impracticable to define and prescribe all such situations where these possible
pressures exist. Reasonableness should prevail in establishing standards for identifying
relationships that are likely to, or appear to, impair auditor’s objectivity.
 Relationships should be avoided which allow prejudice, bias or influences of others to
override objectivity.
 Auditors have an obligation to ensure that personnel engaged on professional services
adhere to the principle of objectivity.
 Auditors should neither accept nor offer gifts or entertainment which might reasonably
be believed to have a significant and improper influence on their professional judgment
or those with whom they deal.

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Professional Competence
Auditors should not portray themselves as having expertise or experience they do not
possess.
Professional competence may be divided into two separate phases:

Phase I Attainment of professional competence

The attainment of professional competence requires initially a high standard of general
education followed by specific education, training and examination in professionally relevant
subjects, and whether prescribed or not, a period of work experience. This should be the
normal pattern of development for auditors.
Phase II Maintenance of professional competence
The maintenance of professional competence requires a continuing awareness of
developments in the auditing profession including relevant national and international
pronouncements on accounting, auditing and other relevant regulations and statutory
requirements.
Auditors should adopt a program designed to ensure quality control in the performance of
professional services consistent with appropriate national and international pronouncements.
Confidentiality
 Auditors have an obligation to respect the confidentiality of information about a client’s
or employer’s affairs acquired in the course of professional services. The duty of
confidentiality continues even after the end of the relationship between the auditors and
the client or employer.
 Confidentiality should always be observed by auditors unless specific authority has been
given to disclose information or there is a legal or professional duty to disclose.
 Professional accountants have an obligation to ensure that staff under their control and
persons from whom advice and assistance is obtained respect the principle of
confidentiality.
 Confidentiality is not only a matter of disclosure of information. It also requires that
Auditors acquiring information in the course of performing professional services does
neither use nor appear to use that information for personal advantage or for the advantage
of a third party.
 Auditors have access to much confidential information about a client’s or employer’s
affairs not otherwise disclosed to the public. Therefore, the professional auditor should be
relied upon not to make unauthorized disclosures to other persons. This does not apply to
disclosure of such information in order properly to discharge the professional
accountant’s responsibility according to the profession’s standards.
 It is in the interest of the public and the profession that the profession’s standards relating
to confidentiality be defined and guidance given on the nature and extent of the duty of
confidentiality and the circumstances in which disclosure of information acquired during
the course of providing professional services shall be permitted or required.
 It should be recognized, however, that confidentiality of information is part of statute or
common law and therefore detailed ethical requirements in respect thereof will depend on
the law of the country of each member body.
When to disclose confidential information?
The following are points which should be considered in determining whether confidential
information may be disclosed:
 When disclosure is authorized. When authorization to disclose is given by the client or
the employer the interests of all the parties including those third parties whose interests
might be affected should be considered.
 When disclosure is required by law. Examples of when the auditor is required by law to
disclose confidential information
20
The law requires the auditor to disclose information to:
 Produce documents or to give evidence in the course of legal proceedings; and
 Disclose to the appropriate public authorities infringements of the law which come to light.
 When there is a professional duty or right to disclose:
Independence
It is in the public interest and, therefore, required by this Code of Ethics, that members of
assurance teams, firms and, when applicable, network firms be independent of assurance
clients.
Assurance engagements are intended to enhance the credibility of information about a subject
matter by evaluating whether the subject matter conforms in all material respects with
suitable criteria. The International Standard on Assurance Engagements issued by the
International Auditing and Assurance Standards Board describes the objectives and elements
of assurance engagements to provide either a high or a moderate level of assurance. The
International Auditing and Assurance Standards Board have also issued specific standards for
certain assurance engagements. For example, International Standards on Auditing (ISA)
provide specific standards for audit (high level assurance) and review (moderate level
assurance) of financial statements.
A Conceptual Approach to Independence
Independence requires:
A. Independence of Mind
The state of mind that permits the provision of an opinion without being affected by
influences that compromise professional judgment, allowing an individual to act with
integrity, and exercise objectivity and professional skepticism.
B. Independence in Appearance
The avoidance of facts and circumstances that are so significant that a reasonable and
informed third party, having knowledge of all relevant information, including safeguards
applied, would reasonably conclude a firm’s, or a member of the assurance team’s, integrity,
objectivity or professional skepticism had been compromised. The use of the word
“independence” on its own may create misunderstandings. Standing alone, the word may
lead observers to suppose that a person exercising professional judgment ought to be free
from all economic, financial and other relationships. This is impossible, as every member of
society has relationships with others. Therefore, the significance of economic, financial and
other relationships should also be evaluated in the light of what a reasonable and informed
third party having knowledge of all relevant information would reasonably conclude to be
unacceptable.
Threats to Independence
Independence is potentially affected by self-interest, self-review, advocacy, familiarity and
intimidation threats.
Self-Interest Threat: Occurs when a firm or a member of the assurance team could benefit
from a financial interest in, or other self-interest conflict with, an assurance client.
Examples of circumstances that may create this threat include, but are not limited to:
 A direct financial interest or material indirect financial interest in an assurance client;
 A loan or guarantee to or from an assurance client or any of its directors or officers;
 Undue dependence on total fees from an assurance client;
 Concern about the possibility of losing the engagement;
 Having a close business relationship with an assurance client;
 Potential employment with an assurance client; and
 Contingent fees relating to assurance engagements.

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Self-Review Threat: Occurs when
 Any product or judgment of a previous assurance engagement or non-assurance
engagement needs to be re-evaluated in reaching conclusions on the assurance
engagement or
 Member of the assurance team was previously a director or officer of the assurance
client, or was an employee in a position to exert direct and significant influence over the
subject matter of the assurance engagement.
Examples of circumstances that may create this threat include, but are not limited to:
 A member of the assurance team being, or having recently been, a director or officer of
the assurance client;
 A member of the assurance team being, or having recently been, an employee of the
assurance client in a position to exert direct and significant influence over the subject
matter of the assurance engagement;
 Performing services for an assurance client that directly affect the subject matter of the
assurance engagement; and
 Preparation of original data used to generate financial statements or preparation of other
records that are the subject matter of the assurance engagement.
Advocacy Threat: Occurs when a firm, or a member of the assurance team, promotes, or
may be perceived to promote, an assurance client’s position or opinion to the point that
objectivity may, or may be perceived to be, compromised. Such may be the case if a firm or a
member of the assurance team were to subordinate their judgment to that of the client.
Examples of circumstances that may create this threat include, but are not limited to:
 Dealing in, or being a promoter of, shares or other securities in an assurance client; and
 Acting as an advocate on behalf of an assurance client in litigation or in resolving
disputes with third parties.
Familiarity Threat: Occurs when, by virtue of a close relationship with an assurance client,
its directors, officers or employees, a firm or a member of the assurance team becomes too
sympathetic to the client’s interests.
Examples of circumstances that may create this threat include, but are not limited to:
 A member of the assurance team having an immediate family member or close family
member who is a director or officer of the assurance client;
 A member of the assurance team having an immediate family member or close family
member who, as an employee of the assurance client, is in a position to exert direct and
significant influence over the subject matter of the assurance engagement;
 A former partner of the firm being a director, officer of the assurance client or an
employee in a position to exert direct and significant influence over the subject matter
of the assurance engagement;
 Long association of a senior member of the assurance team with the assurance client;
and
 Acceptance of gifts or hospitality, unless the value is clearly insignificant, from the
assurance client, its directors, officers or employees.
Intimidation Threat: Occurs when a member of the assurance team may be deterred from
acting objectively and exercising professional skepticism by threats, actual or perceived,
from the directors, officers or employees of an assurance client.
Examples of circumstances that may create this threat include, but are not limited to:
 Threat of replacement over a disagreement with the application of an accounting
principle; and
 Pressure to reduce inappropriately the extent of work performed in order to reduce fees.

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 Safeguards
The firm and members of the assurance team have a responsibility to remain independent by
taking into account the context in which they practice, the threats to independence and the
safeguards available to eliminate the threats or reduce them to an acceptable level.
When threats are identified, other than those that are clearly insignificant, appropriate
safeguards should be identified and applied to eliminate the threats or reduce them to an
acceptable level. This decision should be documented.
The nature of the safeguards to be applied will vary depending upon the circumstances.
Consideration should always be given to what a reasonable and informed third party having
knowledge of all relevant information; including safeguards applied, and would reasonably
conclude to be unacceptable. The consideration will be affected by matters such as the
significance of the threat, the nature of the assurance engagement, the intended users of the
assurance report and the structure of the firm.
Safeguards fall into three broad categories. These are:
1. Safeguards created by the profession, legislation or regulation;
2. Safeguards within the assurance client; and
3. Safeguards within the firm’s own systems and procedures.
The firm and the members of the assurance team should select appropriate safeguards to
eliminate or reduce threats to independence, other than those that are clearly insignificant, to
an acceptable level.
1. Safeguards created by the profession, legislation or regulation, include:
 Educational, training and experience requirements for entry into the profession;
 Continuing education requirements;
 Professional standards and monitoring and disciplinary processes;
 External review of a firm’s quality control system; and
 Legislation governing the independence requirements of the firm.
2. Safeguards within the assurance client include:
 When the assurance client’s management appoints the firm, persons other than
management ratify or approve the appointment;
 The assurance client has competent employees to make managerial decisions;
 Policies and procedures that emphasize the assurance client’s commitment to fair
financial reporting;
 Internal procedures that ensure objective choices in commissioning non assurance
engagements; and
 A corporate governance structure, such as an audit committee, that provides
appropriate oversight and communications regarding a firm’s services.
3. Safeguards within the firm’s own systems and procedures.
Audit committees can have an important corporate governance role when they are
independent of client management and can assist the Board of Directors in satisfying them
selves that a firm is independent in carrying out its audit role.
There should be regular communications between the firm and the audit committee (or other
governance body if there is no audit committee) of listed entities regarding relationships and
other matters that might, in the firm’s opinion, reasonably be thought to bear on
independence.

2.4. Legal Liability and Responsibility of Auditors

We are in the era of litigation in which person real or fenced grievances are likely to their
compliances to courts. In this environment, investors and creditors who suffer financial
reversal find auditor as well as attorney and corporate directors tempting target for law suit

23
alleging professional “mal practice”. Therefore, auditors must approach any engagement
with the prospect that they may be required to defend their work in court.
 In court of defending legal action which may be astronomical are not limited to monetary
measures. For instance
 Law suit can be extremely damaging professional reputation which, if once
damaged is difficult to return back.
 The auditor may even be detained criminally for “mal practice”.

Definition of Legal Terms

Discussion of auditor’s liability is best described by defining some of the common terms of
the business law. The following are few to mention
1. Ordinary or Simple Negligence: Absence of reasonable care that can be expected of a
person in a set of circumstances. When negligence of an auditor is being evaluated, it is
in terms of what other competent auditors would have done in the same situation.
`2 Gross Negligence (also called recklessness or constructive fraud): is a serious
occurrence of negligence tantamount to a flagrant or a reckless departure from the
standard of due care. These terms are frequently used interchangeably and are equivalent
to sloppy auditing or lack of a reasonable basis for a belief. Lack of even slight care in
discharging responsibility.
3. Fraud: Knowledge (intentionally) misrepresenting facts to decide the other party and
with the result that the party is injured. It occurs when a CPA issue an opinion on the
financial statement knowing that the financial statements or the audit report thereon is
false.
4. Privity of contract: is the relationship between two or more parties that creates
contractual duty. In auditing, context, the CPA and the client have a privity or a
contractual relationship that is usually established by a contract called an engagement
letter.
5. Third Party: are those who do not have privity of contract but is known to the
contracting parties and is intended to have certain rights and benefits under the contract.
6. An engagement Letter: A written letter contract summarizing contractual relationship
between the auditor and client.
7. Breach of Contract: Failure of one or both parties in a contract to fulfill the
requirements of the contract.
8. Proximity Cause: Exist when damage to other is directly attributed wrong doing act.
9. The Plaintiff: Is party claiming damage and bringing suit against defendant.
10. Contributory Negligence: Is negligence in the part of the plaintiffs that has contributed
to his/her having incurred a loss.
11. Common Laws: Laws that have been developed through court decisions rather than
through government statutes. An example is an auditor's liability to a bank related to the
auditor's failure to discover material misstatement in financial statements that was relied
on in issuing loan.
12. Statutory Law: is a law that has been adopted by government such as federal
government.
13. Comparative Negligence: is a concept used by certain courts to allocate damages
between negligent parties based on the degree to which each party is at fault. It is also
called as proportionate liability.
2.4.1. Auditors Legal Liability to client
The most frequent source of lawsuit against CPAs is from clients. The suits vary widely
including such claims as failure to complete an unaudited engagement on the agreed upon
date, inappropriate withdrawal from an audit, failure to discover a defalcation, and breaching
the confidentiality requirements of CPAs.

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A typical lawsuit involves a claim that the auditor did not discover an employee defalcation
(theft of assets) as a result of negligence in the conduct of the audit. The lawsuit can be for
breach of contract, a tort action for negligence, or both. Tort action (wrongful act or damage
(not involving breach of contract) for which an evil action can be brought) can be based on
ordinary negligence, gross negligence or fraud. Tort actions are common because the
amounts recoverable under them are normally larger than under breach of contract.
The principal issue in cases involving alleged negligence is usually the level of care required.
Although it is generally agreed that no body is perfect, not even a professional, in most
instances any significant error or mistake in judgment will create at least a presumption of
negligence that the professionals will have to rebut. In the auditing environment, failure to
meet generally accepted auditing standard is often conclusive evidence of negligence.
Auditors Defense against Client Suit
The CPA firm normally one or a combination of four defense mechanisms when there are
legal claims by clients: Lack of duty to perform the service, non negligent performance,
contributory negligence and absence of causal connection.
1. Lack of Duty: Lack of duty to perform the service means that the CPA firm claims there
was no implied or expressed contract. For example, the CPA firm might claim that errors
were not uncovered because the firm did a review service, not an audit. A common ways
for CPA firm to demonstrate a lack of duty to perform the service is by use of an
engagement letter. Many litigation experts believe well-written engagement letters are
one of the most important ways CPA firm can reduce the likelihood of adverse legal
action.
2. Non-negligent Performance: For nonnegligent performance in an audit, the CPA firm
claims that the audit was performed in accordance with Generally Accepted Auditing
Standards (GAAS). Even if there were undiscovered mistakes (errors) or intentional
misstatements or misrepresentations (irregularities), the auditor is not responsible if the
audit was properly conducted. SAS 47 ( AU 312) and SAS 53 ( AU 316) make clear
that an audit in accordance with GAAS is subject to limitations and cannot be relied upon
for complete assurance that all errors and irregularities will be found. Requiring the
auditors to discover all material errors and irregularities would, in essence, make them
insurers or guarantors of the accuracy of the financial statement which is not possible in
general.
3. Contributory Negligence: A defense of contributory negligence by the client means that
the CPA firm claims that if the client had performed certain obligations, the loss would
not have occurred. For example, suppose the client claims that the CPA firm was
negligent in not uncovering an employee theft of cash. A likely contributory negligence
defense is the auditor's claim that the CPA firm informed management of a weakness in
the system of internal control that enhanced the likelihood of the fraud but management
did not correct it. Management often does not correct the internal control weakness
because of cost considerations, attitude about employee honesty, or procrastinations. In
this event of lawsuit of the nature described, the auditor is unlikely to loss the suit,
assuming a strong contributory negligence defense, if the client was informed in writing
of the internal control weaknesses.
4. Absence of Causal connection: To succeed in an action against the auditor, the client
must be able to show that there is a close causal connection between the auditor's breach
of the standard of due care and the damages suffered by the client. For example, assume
an auditor failed to complete an audit the agreed- upon date. The client alleges that this
caused a bank not to renew an outstanding loan, which caused damages. A potential
auditor defense is that the bank refused to renew the loan for other reasons, such as the
weakening financial condition of the client.
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2.4.2. Auditor Liability to Third Party
A CPA firm may be liable to third parties if a loss was incurred by the claimant due to
reliance on misleading financial statements. Third parties include actual and potential
stockholders, vendors, bankers, and other creditors, employees, and customers. A typical suit
might occur when a banker can claim that misleading audited financial statements were
relied upon in making the loan, and that the CPA firm should be held responsible because it
failed to perform the audit with due care.
Auditors Defense against Third Party Suit
Three of the four defenses available to auditor in suit by client are also available in third
party lawsuit. These are:
1. Non-negligence performance
2. Lack of duty to Perform the Services
3. Absence of Causal Connection
Contributory negligence is ordinary not available because the third party is not in apposition
to contribute to misstated financial statement. The preferred defense in third party suit is
nonnegligent performance. If the auditor conducted the audit in accordance with GAAS, the
other defenses are unnecessary. On the other hand, nonnegligent performance is difficult to
demonstrate to the court, especially if it is jury trial and the jury is made up of lay people.
A lack of duty defense in third-party suits contends lack of privity of contract. The extent to
which privity of contract is an appropriate defense depends heavily on the judicial
jurisdiction.
Absence of causal connection in third-party suits usually means non reliance on the financial
statements by the user. For example, assume the auditor can demonstrate that a lender relied
upon an ongoing banking relationship with a customer, rather than the financial statements,
in making a loan. The fact that the auditor was negligent in the conduct of the audit would
not be relevant in that case. Of course, it is difficult to prove nonreliance on the financial
statements.
Auditors Responsibility for detecting Misstatements
The auditors have responsibility to plan and perform the audit to obtain reasonable assurance
about whether the financial statements are free of material misstatement of whether caused
by error or fraud.
Reasonable Assurance: Assurance is a measure of level certainty that the auditor has
obtained at the completion of the audit. Reasonable assurance is not defined in the literature,
but it is presume less than certainnity or absolute assurance and more than low level of
assurance.
Why not absolute assurance?
Nature of audit (limitations) and the characteristics of the fraud, auditors are not in a position
to provide an absolute assurance.
2.6. Materiality and the Auditor
Materiality is an essential consideration in determining the appropriate type of report for a
given set of circumstances. So what is the concept of materiality?
The common definition of materiality as it applies to accounting and, therefore, to the audit
is:
A misstatement in the financial statement can be considered material if knowledge of the
misstatement would affect a decision of a reasonable user of the statement.
In applying this definition, three gradation of materiality are used for determining the type of
opinion to issue.

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Amounts are immaterial : When a misstatement in the financial statements exist, due to of
the two conditions (1) scope restricted by client or by circumstances or (2) statements are not
in accordance with GAAP, but is unlikely to affect the decisions of a reasonable user, it is
considered to be immaterial.
Amounts are material but do not overshadow the financial statement as a whole: The
second level of materiality exists when a misstatement in the financial statement would affect
a users' decision, but the overall statements are still fairly stated, and therefore, useful. For
example, knowledge of a large misstatement in permanent assets might affect a user's
willingness to loan money to a company if the assets were the collateral. A misstatement of
inventory does not mean that cash, accounts receivable, and other elements of the financial
statements, or financial statements as a whole, are materially incorrect.
Amounts are so material or so pervasive that overall fairness of statements is in
question: The highest level of materiality exists when users are likely to make incorrect
decision if they rely on the overall financial statements.
The auditor's responsibility therefore, is to determine whether financial statements are
materially misstated. If the auditor determines that there is a material misstatement, he/she
will bring it to the client's attention so a correction can be made. If the client refuses to
correct the statements, a qualified or adverse opinion must be issued, depending on how
material the misstatement is. Auditors must, therefore, have a through knowledge of the
application of materiality.

Factors Affecting Materiality Judgment

Several factors affect setting a preliminary judgment about materiality for a given set of
financial statements. The most important of these are:
Materiality is a relative rather than absolute concept: A misstatement of a given
magnitude might be material for a small company, whereas, the same birr amount error could
be immaterial for a large one. Hence, it is not possible to establish any birr- value guidelines
for a preliminary judgment about materiality applicable to all audit clients.
Bases are needed for evaluating materiality: since materiality is relative, it is necessary to
have base for establishing whether misstatements are material. Net income before taxation is
normally the most important base for deciding what is material because it is regarded as a
critical item of information for users. It is also important to learn whether the misstatements
could materially affect the reasonableness of other possible base such as current assets,
current liabilities, and owners' equity.
Qualitative factors also affect materiality: certain types of misstatements are likely to be
more important to users than others, even if the birr amounts are the same. For example:
 Amounts involving irregularities are usually considered more important than
unintentional errors of equal dollar amounts because irregularities reflect on the honesty
and reliability of the management or other personnel involved.
 Errors that are otherwise minor may be material if there are possible consequences
arising from contractual obligations.
 Errors that are otherwise immaterial may be material if they affect a trend in earnings.
For example, if reported income has increased 3 percent annually for the past five years,
but income for the current year has declined 1 percent, that change of trend may be
material. Similarly, an error that could cause a loss to be reported as a profit would be of
concern.

2.7. Error and Fraud

Error – An error represents an unintentional misstatement of the financial statement. It may
be material or immaterial.
- Mistake in gathering and reporting data

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 - Mistake in application of GAAP
- Unintentional omission of amount
- Informative disclosure on financial statement.
Fraud: Fraud represents an intentional misstatement of the financial statement which can be
material or immaterial. The misstatement due to fraud may occur due to either of:
1. Misappropriation of assets defalcations or employee fraud. E.g. theft of cash or another
asset.
2. Fraudulent financial reporting often called management fraud. E.g. intentional
misstatement of sales near the balance sheet date to increase reported earning.
2.8 Truth and Fairness
The term truth and fairness are essential elements of audit report. There is no statutory or
professional definition of truth and fairness. Truth and fair is a technical in the phrase to be
looked at as entirely. In general, the word "true" means, information is factual confirms to
reality, not false. The information confirms with standards.
Fairness means; clear distinct and plain
- Impartial, not biased or
- Just and equitable
To show true and fairness accounts must be prepared
- In accordance with GAAP
- On constant basis so as net to be misleading
- The accounts must be taken from books and records.
2.9: Appointment, Remuneration and Removal of auditors in Ethiopia
The Commercial Code of Federal Democratic Republic of Ethiopia set how auditors are
appointed, remunerated, and removed and also their responsibilities to third parties and the
clients. The following section deals with the appointment remuneration and revocation of
auditors especially those of auditors appointed to the public.
Article 368 Appointment of auditors
(1) The general meeting of every company limited by shares shall elect one or more
auditors and one or more assistant auditors
(2) Shareholders representing not less than 20 % of the capital may appoint an auditor
selected by them
(3) Where there is more than one auditor, they may exercise their duties jointly or
separately
(4) A body corporate may act as auditor
Art. 369- Nomination and term of Appointment
(1) Auditors shall be elected by the meeting of subscribers and thereafter by the annual
general meeting
(2) Auditors elected by the meeting of subscribers shall hold office until the first annual
meeting. Auditors elected at an annual general meeting hold office for three years
(3) When signing as auditor, an auditor shall add the name of the company whose
accounts he is auditing.
Art.370. Persons Not Competent
(1). the following persons may not be elected as auditors
(a) Founders, contributors in kind, beneficiaries holding special benefits, directors of the
company or of one of its subscribers or of its holding companies

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 (b) Spouses or relatives by consanguinity of affinity to the fourth degree inclusive, of the
person mentioned in sub-art-(1) (a)
(c) Person who receives from the persons mentioned in sub- art. (1) (a) a salary or
periodical remuneration in connection with duties other than those of an auditors.
(2) Auditor may not be appointed directors or managers of the company which they audit,
nor of one of its subscribers or its or of its holding company with in three years
from the date of the termination of their functions.
(3) Reports submitted by an auditor and adopted by the annual general meeting shall not,
save in the case of fraud, be invalid merely by reason of the fact that the provisions
of this Article have not been observed.

Art 372. Remuneration

(1) The remuneration of auditors shall be fixed by the general meeting on their
appointment
(2) Where the general meeting fails to agree on the remuneration of the auditors, the
Ministry of commerce and Industry may on the application of any interested party fix
the remuneration.
Art. 371. Revocation of the appointment of Auditors
A general meeting may at any time revoke the appointment of any auditor without prejudice
to any claim he/she may have for wrongful dismissal.

2.10. Client acceptance Procedure

Auditing is a time-sensitive and risk-intensive business. Financial controversy and fraud has
raised the bar on auditing firm diligence. A critical step in an auditing firm establishing
strong credentials and minimizing risk is obtaining clients that are dependable, financially
secure and present a low risk for fraud. The most successful audit client acceptance
procedures reduce legal and financial risk by accepting only companies with strong operating
and financial track records. Hence the auditor should review the following points.
1. Prior Audit Review: Review the reasons why a company is looking for a new
auditor. It may be the company is performing due diligence and looking for a lower cost
option for audit reviews, or the company may be a new firm that has just increased revenues
to the point where it needs an audit. Likewise, a company may be looking for a new firm
because it has run into conflicts with prior auditors. Conflicts could include audit procedures
the company did not like or payment problems. A former auditing firm may have dropped the
company for failing to comply with audit requests or for routine late payments. As an
auditing firm, you should decide how much risk you are willing to take with a company that
has an unreliable auditing past.

2. Ratings and Public Records: The financial ratings and public records of a company
should be reviewed before an audit client is accepted. Review credit reports, legal history, tax
problems, litigation records, regulatory actions, bankruptcy issues, consumer complaints and
professional liability claims. Require the company to provide business references for review.
A solid review of a company's professional and public dealings will provide good insight into
the stability and functioning of the company.
3. Reputation: Your reputation as an auditing firm is partly based off the companies
you audit. Ensure the image of your auditing firm by only accepting clients who share the
same ethical and business integrity foundation as your firm. Interview senior management
and executives to gain an understanding of their business principles. Look into the
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background of the key players in the business for any criminal or legal problems and at their
personal reputation in the business community. Determine if the company pays their bills on
time and honors contracts and agreements. Avoid any client that has a long history of
litigations as a defendant or as a plaintiff.
4. Business Structure: Review the business structure of a potential client. Look for red
flags such as overseas plants or operating facilities, high turnover in upper management and a
short operating history. Also review the company's legal counsel to see if they a have stable,
well-known legal firm, or unknown or shady representation. Review the company's physical
business presence. How long a business has stayed in the same location is an indication of
stability.
Approval: Once all the relevant procedure and information gathering takes place the
company can put forward for approval. The engagement partner will have completed a client
acceptance form and this along with any other relevant documents will be submitted to the
managing partner or which ever partner is in over all charge of accepting clients.
2.11 Engagement Letter
Engagement letter is the letter that summarizes contractual relationship between the auditor
and the client. It defines clearly the extent of the auditors’ responsibility and so minimizes
the possibility of any misunderstanding between the client and the auditors.
2.12 proclamations related to auditors liability to third parties and the client
Art. 380 of the commercial code of the Ethiopian constitution deals with the auditor's liability
to third parties and to the client.
(1) Auditors shall be civilly liable to the company and third parties for any fault in the
exercise of their duties which occasioned loss
(2) An auditor who knowingly gives or confirms an untrue report concerning the position of
the company of fails to inform the public prosecutor of an offence which he knows to
have been committed shall be punished under Art.438 of Art. 664 of the Penal code, as
the case may be.
Offences and Penalty
1.  Any person who:
Fails to produce or make available books, documents, ledgers, vouchers or any other
documentary or oral evidence which the Federal Auditor General Directly or through his
employees or his representatives requires for auditing; or
Gives to the Federal Auditor General, the Auditors of the office of the Federal Auditor
General or its representatives any information which he knows to be false or which he has no
reason to believe to be true; or
Obstructs the proper carrying out of the functions of the Federal Auditor General; or
Fails to, take measures, within 30 days from the date of delivery, on recommendations and
comments included in the audit report of the Federal Auditor General; or fails to comply with
the provisions of this Proclamation when he is required to do so;
Shall be punished with imprisonment from 5 to 7 years or with a fine of Birr 10,000 (ten
thousand Birr) or with both such fine and imprisonment.
2.  Any Auditor who:
In consideration for the performance or for the omission of an act in violation of the duties
proper to his office solicits, exacts a promise of or receives a gift, money or any other
advantage; or
accepts any auditable document as genuine where he knows that is not or unduly rejects any
valuable document submitted to him by the one to be audited; or
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 a. defrauds or cooperates with others by creating conducive conditions so that they can
defraud or conspires in defrauding money of the federal Government; or 
b. with intent to obtain or procure undue advantage for himself or to a third person or to
cause a harm on any other person, causes to disappear or falsify or cause to be falsified or
forges any books, documents, ledgers, vouchers or any other evidence submitted to him
by the one to be audited:
c. Shall be punished with imprisonment from 5 to 10 years and with a fine from 10,000 up
to Birr 15,000 (ten thousand up to fifteen thousand Birr).

UNIT THREE
AUDITING PRINCIPLES AND TOOLS

3.1 Auditing Principles and Standards

Principles are general guidelines that help direct or chart goals and aims. Auditing principles thus
are broad guidelines that help identify auditing goals and objectives or help to direct efforts
towards goals. Principles are based on concepts or assumptions and/or developed from a particular
observation and convention/custom. There are certain basic principles that underlie every audit.
An auditor has to ensure compliance with these principles in carrying out any audit. Therefore, he
has to design his audit procedures and reporting practices in an auditing situation that he can
comply with these basic principles.

Auditing profession in many countries have attempted to embody these guidelines in their
professional association emblem. For example, in USA and UK, Truth, Fairness, and Objectivity
were identified as basic auditing principles. Others have tried to base their auditing principles on
accounting principles themselves. In Ethiopia, for example, the Ethiopian professional association
of Accountants and Auditors (EPAAA) had the following as principle guidelines in its emblem
“Forth Rightness or Uprightness above all”

Standards are authoritative rules for measuring the quality of performance. They serve as rods
against which work performed is compared and thus principles are translated in to more practical
and adherable terms. In this regard standards are more specific than principles. The American
Institute of certified Public accountants (AICPA) has formulated the following 10 generally
Accepted Auditing Standards (GAAS) categorized in to three. The following diagram depicts the
10 GAASs categorized in to three broad classifications.
Generally Accepted
Auditing Standards

A) General Standards B) Standards of Field Work C) Standards of Reporting

Adequate Training Proper planning & In Accordance with

& proficiency supervision GAAP
Understanding Internal Deviations from
Independence control GAAP
Adequate Disclosure
Due professional Sufficient &
care Competent Evidence Expression of
opinion

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 A. GENERAL STANDAREDS
1. Adequate Training and Proficiency: The audit is to be performed by a person or persons
having adequate technical training and proficiency as an auditor. How does the independent
auditor achieves the adequate technical training and proficiency required by the first general
standard? 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 participation in continuing education program. A
technical knowledge of the industry in which the client operates is also part of the personal
qualification of the auditor. It follows that a CPA firm must not accept an audit engagement
without first determining that members of its staff have the technical training and proficiency
needed to function effectively in particular industry.

2. Independence: In all matters relating to the auditing assignment, independence in mental

attitude and in appearance is to be maintained by the auditor or auditors. An opinion by
independent public accountant as to the fairness of a company’s financial statement is of no
value unless the accountant is truly independent. Consequently, the auditing standard that
state in all matters relating to the assignment, an independent in mental attitude is to be
maintained by the auditors, perhaps is the most essential factor in the existence of a public
accounting profession. If an auditor owned shares of stock in a company that they audited, or
if they served as members of the board of directors, they might subconsciously be biased in
the performance of auditing duties. A CPA should therefore avoid any relationship with the
client that would cause an outsider who had knowledge of the facts to doubt the CPA
independent. It is not enough that the CPA be independence, they must conduct themselves
in such a manner that informed members of the public will have no reason to doubt their
independence.

3. Due Professional Care: the third general standard requires due professional care in the
conduct of an audit and in the preparation of the audit report. This standard requires the
auditor to carry steps of the audit engagement in an alert and diligent manner. Full
compliance with this standard would rule out any negligent acts or material omissions by the
auditors. Of course, auditors, as well as members of other profession, inevitably make
occasional errors in judgment, but this human element doesn’t justify indifference or
inattention to professional responsibility.
B. STANDAREDS OF FIELD WORK
4. Adequate Planning and Supervision: adequate planning is essential to a satisfactory
audit. Some portion of the examination can be performed prior to the end of the year under
audit: some information may be completed by the client’s staff and made available for the
auditors review. The appropriate number of audit staff of various levels of skill and the time
required of each need to be determined in advance of filed work. These are but a few of the
elements of planning the audit. Most of the filed work of an audit is carried out by staff
members with limited experience. The key to successful use of relatively new staff members
is close supervision at every level. This concept extends from providing specific written
instruction to staff members all the way to an overall review by the partner in charge of the
engagement.

5. Sufficient Understanding of Internal Control: An excellent internal control structure

provides strong assurance that the clients records are dependable and that its assets are
protected. When the auditor find this type of strong internal control, the quality of other

32
evidence required is much less than if control were weak. Thus, the auditor’s assessment of
internal control has great impact on the length and nature of the audit process.

6. Sufficient Competent Evidential Matter

The third standards of filed work require that the auditor gather sufficient competent
evidence to have a basis for expressing an opinion on the financial statement. The word
“competent” refers to the quality of the evidence; some forms of evidence are stronger and
more convincing than other.

C. STANDARDS OF REPORTING
There are four reporting standards that require the auditor to prepare a report on the financial
statement taken as a whole, including informative disclosure. The reporting standards
requires that the report states whether the statements are presented in accordance with GAAP
and also identify any circumstances in which GAAP have not been consistently applied in the
current year compared with the previous one.
7. In Accordance with GAAP: The report shall state whether the financial statements are
presented in accordance with Generally Accepted Accounting Principles.
8. Deviations from GAAP: The report shall identify those circumstances in which such
principles haven’t been consistently observed in the current period in relation to the
preceding period.
9. Adequate Disclosure: Informative disclosures in the financial statements are to be
regarded as reasonably adequate unless otherwise stated in the report.
10. Expression of Opinion: 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 cannot be expressed; the reasons therefore, should be stated. In all cases where an
auditor’s name is associated with financial statements, the report should contain a clear-cut
indication of the character of the auditor’s work, if any, and the degree of responsibility the
auditor is taking.

The above 10 standards are also acceptable by the Canadian institute of chartered accountant
and more or less by many UK professional public accounting associations (ACCA and CA).
Therefore we can say that these standards are acceptable worldwide

3.2 Auditing Procedures and Techniques

Procedures are steps of action taken in the process of verification or accomplishing specific
tasks to be performed. Auditing procedures are identified and selected in relation to particular
item to be verified i.e. each, accounts receivables, inventory etc. The auditor is supposed to
assume full responsibility for selection of these procedures according to circumstances. They
should not be considered exhaustive and conclusive and are at times intermixed with
techniques. The followings are examples of auditing procedures which we will discuss them
in detail the second part of principles of auditing
 Vouching  Scanning
 Comparing  Analyzing
 Checking  Testing
 Reconciling  Inquiry
 Inspection  Observation

Auditing Technique: is defined as any technique used by auditors to determine deviations

from actual accounting and controls established by a business or organization as well as
uncovering problems in established processes and controls. Auditing techniques can be used
33
to aid organizations by uncovering errors in business practices and providing a means of
correction. Some businesses have used irregular accounting methods to hide certain monetary
transactions and non-compliant behavior which has been uncovered by the use of varied
auditing techniques. Other businesses have found new ways to save money and streamline
business practices through various auditing techniques which have found waste in certain
processes.

Auditing techniques can be used to uncover these issues in order to ensure ethical business
practices and to minimize waste or possible oversights within an organization. The applied
techniques can determine if any income is hidden or improperly categorized or reported;
transactions are being completed between the organization and regulated or prohibited
persons, groups, or countries; uncovering of environmental waste discrepancies; finding of
data inconsistencies; or any other business practice that can be considered as a process error,
oversight, or violation of ethics, regulations, and laws.

3.3 Audit Approaches

Audit approach is a point of view, an attitude or a deposition, which influence the procedures
and techniques adapted to circumstances. Different approaches could be adapted for different
purpose and circumstances or objects. The followings are some approaches commonly
identified as influencing verification process.

Defensive Approach: In this approach, the auditor is very cautious; she/he is suspicious that
there is always fraud or an error, which might be concealed from her/him, or someone is
trying to hide from being discovered. Thus, the auditor is prepared to fight fraudulent efforts
to conceal and becomes highly keen on methods that help detect fraud. Hence, the auditor
may at times not be satisfied unless manages to find one. The auditor adapts an attitude that
the auditee is guilty unless proven innocent. The drawback of this approach is it may further
all the negative image on an auditor in the public.

Positive Approach: In this case, the auditor has a constructive attitude: based on the premise
that a person is innocent until proven guilty. Rather than directing efforts to detecting error,
efforts are directed to establishing its conditions, which lead to what should be acceptable.
She/he looks for explanations and possibilities that lead to conclusion. This approach may
lead the auditor to be easily fooled unless she/he is careful.

Inventory Approach: this approach directs the auditor to find evidences by retracting to or
corroborating figures with physical evidence and reconciling documentary evidences to
physical evidences. Such techniques are usually applicable in cash, and inventory counts
Transaction Approach: the auditor in this case concentrates the efforts on transactions or
events, reconstructing accounts of transactions or tracing amounts back to initial events.
Analytical Approach: In this approach, the auditor performs the audit work through the
review of internal control analysis. This approach involves studying and analyzing
circumstantial evidences or indirect evidences, which leads to developing techniques of
evaluating internal control system and procedures.
Business Approach: the auditor’s attitude in this approach is not just to establish figures by
tracing to books, but rather to assess whether the figures on financial statements and accounts
make sense from the point of view of market conditions, business and economic sense.
Vouching Approach: Under the vouching approach, the auditor looks for supporting
documentary evidences, whether of primary or secondary sources. Usually she/he relies on
source documents.

34
System Based Approach: as its name designates, the process involves systematic approach
to understanding the operational system and its control devices; and testing whether the
system works as it should, or audits or controls itself, to establish its strength and weakness
and determines reliability of its inputs and out results. Internal control review is part and
parcel of this process although the development and use of this approach has become popular
with information technology development and flow charting
Risk Based Approach: This is the most recent approach to audit. Risk associated with
various audits activates and related decisions are assessed to select audit procedures to
determine time to be applied and identify quality of supporting evidence. This is important to
establish extent of audit program and plans. Area of focus is by risk weight. Risks assumed
are guided by the level of assurance needed to obtain evidence and concomitant cost. Thus
the higher the risk object, the more intensive the audit is, and costly too.

3.4 Financial Statement Assertions

Assertions are expressed or implied representation by the management that are reflected in
the financial statement components. For example, when the balance sheet contains account
receivable of Br. 5 million, management asserts that receivables exist and have a net
realizable value of Br. 5 million. Management also asserts that the account receivables
balances arose from selling goods or services on credit in the normal course of the business.
In general, the assertions relates to the requirements of GAAP. These assertions are parts of
the criteria management uses to record and disclose accounting information in financial
statements. Auditors must there for understand the assertions to adequately audit. That is to
confirm client’s financial statements to GAAP. Auditing standard classifies assertions in to
five categories
1. Existence or Occurrence Assertion: these deals with whether transactions recorded in
journal or balances in the ledger have actually occurred during a given period and whether
assets or liabilities of the entity actually exist at a given date. For example, management
asserts that inventory shown on the balance sheet physically exists and is available for sales.
Similarly, management asserts that revenue reported in the income statement represents valid
sales that occurred during the period
2. Completeness: assertion about completeness address whether all transactions and
accounts that should be presented in the financial statement are included. For example
management asserts that inventory represent all items on hand at the balance sheet date.
Managements also implicitly asserts that the amount shown for account payable on the
balance sheet includes all such liabilities on the balance sheet date
3. Right and Obligation: assertion about rights and obligation address whether assets are the
rights to the entity and liabilities are obligations of the entity at a given date. For example,
management asserts that the entity has legal title or rights of ownership to the inventory
shown on the balance. Similarly amounts capitalized for lease reflects assertions that the
entity has right to leased property and that the corresponding lease labiality represents an
obligation of the entity.
4. Valuation or Allocation: assertions about valuation and allocation address whether assets,
liabilities, equities, revenue and expense components have been included in the financial
statements at appropriate amount. For example, management asserts that inventory is carried
at the lower of cost or market value on the balance sheet date. Similarly, managements assert
that the cost of property, plants and equipments is systematically allocated to appropriate
accounting periods by recognizing depreciation expense.
5. Presentation and Disclosure: assertion about presentation and disclosure address whether
particular components of financial statements are properly classified, described and
disclosed. For example, management asserts that the portion of long term debt shown as
current liability will mature in the current year. Similarly, managements assert, through
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footnote disclosure that all major restriction on the entity resulting from debt covenants is
disclosed.

3.5 Audit Objectives

In obtaining evidence to support the assertion contained in the financial statements, the
auditor develops audit objectives that relates to each management assertion. Audit objectives
tests the assertions contained in the components of financials statements. These objectives
are both general and specific audit objectives. Once the auditor has sufficient evidence that
the set audit objectives are met, he or she has reasonable assurance that the financial
statement is fairly stated. The following section discusses the general and specific audit
objectives in more detail.

1. Validity: the validity objective relates to the existence or occurrence assertion and is
concerned with whether the transactions included in the account are valid or that they exist.
The auditor’s main concern is that the account balances are not overstated due to fictitious
amounts. For example, to test the validity of account receivable, the auditor might confirm
the customers balance. A customer’s acknowledgment that the amount is owed provides
evidence on the validity of the recorded accounts receivable.
2. Completeness: the completeness objective relates to the management assertion of
completeness and address whether all transaction are included in the account. For example, if
the client fails to record sales or purchase transaction, the financial statement will be
misstated. Note that, the auditor’s concern with completeness is opposite to the concern for
validity. Failure to meet the completeness objective results in an understating an account,
while invalid recorded amount results in an account being overstated. For example, to test the
completeness objectives for accounts receivable, the auditor compares the total of the
accounts receivable subsidiary ledger to the account receivable control account in the general
ledger. If the totals do not agree, some sales transactions and the related account receivables
may not have included in the clients accounting records.
3.Cutoff: the cutoff objectives is primarily related to the completeness assertion and is
concerned with whether the transaction included in the account, if valid are recorded in the
proper period. The audit procedure must ensure that transactions occurring near the year end
are recorded in the financial statement in the proper period.
4. Ownership: this objective addresses whether the asset and liability belong to the entity
and relates to management’s assertion about right and obligation. If the entity does not have
rights to an asset, or if a liability is not the entity’s obligation, it should not be included in the
financial statements.
5. Accuracy: the accuracy objective relates to the valuation or allocation assertion and
addresses proper accumulation of transaction and amounts from journals and ledgers. For
example, auditors frequently use aged trail balances to document the detailed in accounts
receivable subsidiary ledger. To test the aged trail balance accuracy, the auditors foot the
aged trail balances and traces selected customer accounts from the aged trail balances to the
account receivable subsidiary ledger for proper amount and aging
6. Valuation: the valuation objective relates to the valuation or allocation assertion and is
concerned with ensuring that the account shown in the financial statements are recorded at
the proper amount. Generally accepted accounting principles establish the valuation method
for a particular transaction or account balance. For example, account receivable are
accounted for at net realizable value; that is, the allowance for doubtful accounts is used to
adjust gross account receivable to the balance excepted to be collected. The auditor tests the
adequacy of the allowance for uncollectible accounts by examining the entities past bad debt
experience relatives to the current balance in the allowance account.

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8. Classification: it is important that transaction be included in the correct account and the
account is properly presented in the financial statements. For example, in auditing accounts
receivable, the auditor examines the listing of account receivables to ensure that receivables
from affiliates, officers, directors, or other related parties are classified separately form trade
receivables. The classification objectives relates to the presentation and disclosure assertions.

9. Disclosure: This audit objective relates directly to the presentation and disclosure
assertion and is concerned with ensuring that all required financial statements and footnote
disclosures are made. For example, if account receivables are pledged as security for debt,
such information should be disclosed in the financial statements. Similarly, if a long term
debt agreement contains major covenant (such as limits on payments of dividend or issuance
of additional debt), that information should be disclosed.

The following table shows management assertions, general audit objectives and specific audit
objectives for inventory.
Management General Specific Audit Objective
Assertion Objective
Existence or Validity All recorded inventory exist at the balance sheet date
Occurrence
Completeness Completeness All existing inventory has been included in the account
Rights and Obligations Ownership The company has title to all inventory items listed
Valuation or Valuation Inventory quantity agrees with items physical on hand
Allocation Price used to value inventory are correct
classification Inventory items are properly classified to raw material,
work in process and finished goods
Cutoff Purchase and sales cut off at the end is proper
Mechanical Total of inventory items agree with general ledger
accuracy
Presentation and Disclosure The pledge and consignment of inventory is disclosed
Disclosure
3.6 Audit Planning
The first Generally Accepted Auditing Standards of fieldwork requires adequate planning to
be made before auditing is carried out. Reasons for proper audit plan includes
 To enable the auditor obtain sufficient competent evidence
 To help keep audit costs reasonable
 To avoid misunderstanding with the client
Obtaining sufficient competent evidence is essential if the CPA wants to minimize legal
liability and maintain a good reputation in the business community keeping costs reasonable.
It helps the firm remains competitive and thereby retains or expands its client base, assuming
the firm has a reputation for doing high-quality work. Avoiding misunderstanding with the
client is important for good client relations and for facilitating high-quality work at
reasonable cost. The followings are the elements of audit planning:
1. Preplanning
2. Obtain background information
3. Obtain information about clients legal obligation
4. Perform preliminary analytical procedures
5. Set materiality, and assess acceptable audit risk and inherent risk
6. Understand internal control and assess control risk
7. Develop overall audit plan or audit program
As shown above, there are seven major parts of Audit planning. Each of the first six parts are
intended to help the auditor develop the last part, an effective and efficient overall audit plan
and audit program.
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 1. Preplan the Audit: Preplanning the audit involves four things, all of which should be
done early in the audit.
 A decision whether to accept a new client or continue serving an existing one
 Identification of why the client needs an audit
 Obtaining an understanding with the client about the terms of engagement to
avoid misunderstandings.
 Select staff for engagement
Investigation of new client and reevaluation of existing ones is important to assess the
integrity of the client and to assess the acceptable financial risk it will assume. If the CPA
firm decides that acceptable risk is extremely low, it may choose not to accept the
engagement. If the CPA firm concludes that acceptable audit risk is low but the client is still
acceptable, it is likely to affect result and the fee proposed to the client, Audits with low
acceptable audit risk will normally result in higher audit costs, which should be reflected in
higher audit fees.

Obtaining an understanding with the client is expressed by the use of engagement letter,
even though it is not required. Engagement letter is an agreement between the CPA firm and
the client for the conduct of the audit and related services. It should specify whether the
auditor will perform an audit, a review, or a compilation, plus any other service such as tax
returns or management consulting. It should also state any restriction to be provided for the
audit, an agreement on fees. The engagement letter is also a means of informing the client
that the auditor cannot guarantee that all acts of fraud will be discovered. Selection of staff
for engagement involves the assignment of appropriate staff to the engagement if the CPA
firm decides to accept the client and conduct the audit. Selection of audit staff is important to
meet the first requirement of generally accepted auditing standard and to promote audit
efficiency. The first GAAS stats “that the audit is performed by a person or persons having
adequate technical training and proficiency as an auditor”.

2. Obtain Background Information: An extensive understanding of the client business and

industry and knowledge about the company’s operation are essential for doing adequate
audit. There are three reasons for obtaining a good understanding of the clients industry.
First, many industries have unique accounting requirement that the auditor must understand
to evaluate whether the clients financial statement are in accordance with GAAP. Second,
auditors can often identify risks that may affect the auditor’s assessment of acceptable audit
risk, or even whether auditing companies in the industry is advisable.
Finally, there are inherent risks that are typically common to all clients in certain industry.
Understanding those risks aids the auditor in identifying the client’s inherent risk.
Knowledge of the clients industry can be obtained in different ways. These includes:
 Discussion with previous auditor
 Discussion with clients personnel
 Tour the plant and office of the clients
 Discussion with outside specialists.
3. Obtain Information about Client’s Legal Documents: Early knowledge of the legal
documents and records enables auditors to interpret related evidence throughout the
engagement and to make sure there is proper disclosure in the financial statement. Three
closely related types of legal documents and records should be examined early in the
engagement.
 The Corporate Charter and the Bylaws: The corporate charter is granted by
the state in which the company is incorporated and is the legal document
necessary for recognizing a corporation as a separate entity. It includes the
exact name of the corporation, the date of incorporation, the kind and amount
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 of capital stock the corporation is authorized to issue and the types of business
activities the corporation is authorized to conduct. The bylaw includes the
rules and procedures adopted by stockholders of the corporation; they specify
such things as the fiscal year of the corporation, the frequency of stockholders
meetings, and the methods of voting for directors, and the duties and power of
the corporate offices.
 The Corporate Minutes: are the official records of the meetings of the
boards of directors and stockholders. They include summaries of the most
important decision made by the directors and stockholders. The auditors
should read the minute to obtain information that is relevant to perform the
audit including the authorization and discussion by the board of directors
affecting inherent risk.
 Contracts: clients involved in different types of contracts that are interested
to the auditors. These can include various items such as long term notes and
bonds payable, stock option, pension plane, contracts of manufactured
products, contracts with vendors for future deliveries of supplies, government
contacts and leas.
4. Performing Preliminary Analytical Procedures: Auditors are required to perform
analytical procedures while planning the audit to assist the auditor in determining the nature,
timing and extent of auditing procedures. Analytical procedures made during the planning
phase enhance the auditors understanding of the client’s business and events occurring since
the prior year’s audit. Planning analytical procedures also help the auditor identify areas that
may represent specific risks of material misstatement warranting further attention.

5. Audit Risk Assessment and Materiality: Audit risk represent the risk that the auditor
will conclude that financial statement are fairly stated and unqualified opinion can be issued
when in fact they are misstated. Audit risk refers to the possibility that the auditor may
unknowingly fail to appropriately modify their opinion on financial statement that is
materially misstated.
Audit risks are divided in to four:
a) Inherent Risk
b) Control Risk
c) Detection Risk
d) Acceptable Audit Risk
a. Inherent Risks: is a measure of the sensitivity or susceptibility of the financial statement
account to material misstatement before considering the effectiveness of internal control,
accounting controls, policies or procedures. Internal control is ignored in setting inherent risk
because they are considered separately in audit risk assessment as control risk.
b. Control Risk: is the risk that a material misstatement will not be prevented or detected on
timely basis by the clients internal control structure. Control risk represent an assessment of
whether clients internal control structure is effective for prevention or detecting error and the
more effective the internal control, the lower the control risk
c. Detection Risk: is the audit risk that the auditor will fail to detect material misstatement
with their audit procedures. It is the possibility that audit procedures will lead them to
conclude that a material misstatement does not exist in an account, in fact such misstatement
does exist. Detection risk is a function of the procedures auditors perform for testing
assertions.
d. Acceptable Audit Risk: is the measure of how willing the auditor is to accept that the
financial statement may be martially misstated after the audit is completed and unqualified
opinion has been issued. When the auditor decides on lower acceptable risk, the auditor
wants to be more certain that the financial statement will not materially misstated. Zero

39
acceptable risk would be high certainty and 100% acceptable audit risk would be complete
uncertainty. The primary way that the auditors deal with risk in planning audit evidence is
through the application of the audit risk model. The audit risk model is used primarily for
planning purposes in deciding how much evidence to accumulate in each cycle.

PDR = __AAR_
IR X CR
Where:
PDR = planned Detection risk
AAR = acceptable audit risk
IR = inherent risk
CR = control risk
Example: Assume that the auditor have assessed inherent risk for a particular assertion at
50% and control risk at 40%. In addition, they have performed audit procedures that they
believe have a 20% risk of failing to detect a material misstatement in the assertion. Compute
the acceptable audit risk.
Solution
PDR = __AAR_
IR X CR
0.20 = __AAR_
0.50 X 0.40

AAR = 0.04 = 4%
7. Develop an Over All Audit Plan
The last step in the planning the audit is to develop an over all strategy. This involve about
the nature, extent, and timing of audit test to be conducted. The audit strategy is normally
documented in an audit plan and audit program containing specific audit procedures. The
audit program for most audits is designed in three parts:
1. Test of transactions
2. Analytical procedures
3. Test of details of balance
3.7Auditor’s Working Paper
Working papers are the records kept by the auditor of the procedures applied, the test
performance, the information obtained and the pertinent conclusions reached in the
engagement. The over all objectives of working paper are to aid the auditor in providing
reasonable assurance that an adequate audit was conducted in accordance with GAAS. The
working papers as they pertains to the current years has the following purpose
 Provide a base for planning the audit, because the working papers describe
information about internal control structure, a time budget for individual audit
areas, the audit program and the results of the preceding year’s audit.
 A record of the evidence accumulated and the result of the test
 Data for determining the proper type of audit
 Basis for review by supervisor and partner. The working papers are the primary
frame of reference used by supervisory personal to evaluate weather sufficient
competent evidence was accumulated to justify audit reports.
Working papers contain virtually every thing involved in the examination. The filling of
working paper is classified in to the following.
1. Permanent Files: are intended to contain data of a historical or continuing nature
pertinent to the current examination. The permanent files typically include the following.
 Extracts or copies such as articles of in corporation, by laws and contracts.

40
  Analysis from previous years of accounts that have continuing importance to the
auditor such as long term debt, stock holders equality accounts, good will and
fixed asset.
 Information related to the understanding of the internal control structure and
assessment of control risks such as organization charts, flowcharts questioners etc.
 Result of analytical procedures from previous year’s audit such as ratio and
percentage computed by the auditor.
 Total balance for selected accounts.
2. Current Files: The current files include all working papers applicable to the years
under audit. The types of information included in the current file are:
 Audit program
 General information like planning memos, copies of minutes, agreements notes on
discussion with client etc.
 Working trial balance, listing of the general ledger account and their year end
balance including subsidiary balance and account.
 Adjusting and reclassification entries
 Supporting schedule such as analysis of account trail balance, reconciliation of
amounts, test of reasonableness, summary of procedures, examination of
supporting documents, outside documentation.

The working paper prepared during the engagement, including those prepared by the
client for the auditor are the property of the auditor. The only time any one including the
client has legal right to examine the paper is, when they are subpoenaed by the court as
legal evidence. At the completion of the engagement, working paper is kept at the
auditors premise for future reference. The working paper can be provided to some one
else with expressed permission of the client

UNIT FOUR

INTERNAL CONTROL SYSTEMS

4.1 Meaning of Internal Control
Differences of opinion have long existed about the meaning & objectives of internal control.
Many people interpreted the term internal control as the steps taken by a business to prevent
fraud-both misappropriation of assets and fraudulent financial reporting. Others while
acknowledging the importance of internal control for fraud prevention believed that internal
control has an equal role in assuring control over manufacturing and other processes. In the
broadest sense, an enterprise’s internal control structure consists of the policies and procedures
established to provide reasonable assurance that organization’s objectives will be achieved.

A process, effected by the entity’s board of directors, management, and other

personnel, designed to provide reasonable assurance regarding the achievement of
objectives in the following categories:
 Reliability of financial reporting.
 Effectiveness and efficiency of operations.
 Compliance with applicable laws and regulations.

After the establishment of the Committee of Sponsoring Organizations [COSO] by major

professional organizations, the committee commissioned a study established a common definition
of internal control. The study was titled as Internal Control-Integrated Framework, and defines
internal control as:
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The above three categories in the definition can be explained as follows:
 Reliability of financial reporting- Management has both legal and professional
responsibility to be sure that the information presented in the financial statements for
investors, creditors, and other users is fairly prepared in accordance with the reporting
requirements; Generally Accepted Accounting Principles.
 Enhancing efficiency and effectiveness of operations - Adequate control system should
be established by organizations to encourage efficient and effective utilization of resources
(financial, human and material) to optimize the company's goals and objectives. On top of
this, internal control systems should safeguard assets and records of the organization from
theft, misuse, embezzlements, misappropriations and accidental damages.
 Compliance with applicable laws and regulations - There are many laws regulations
and procedures that organizations are required to follow some of which are only indirectly
related to accounting (environmental protection and civil rights laws). Others such as
income tax regulations and fraud are closely related to accounting.

COSO’s definition of internal control emphasizes that internal control is a process, or a means to
an end, and not an end by itself. The process is effected by individuals, not merely policy manuals,
documents, and forms. By including the concept of reasonable assurance, the definition
recognizes that internal control cannot realistically provide absolute assurance that an
organization’s objectives will be achieved. Reasonable assurance recognizes that the cost of an
organization’s internal control system should not exceed the benefit expected to be obtained.

The American Institute of Certified Public Accountants [AICPA] defined internal control as
follows:

Internal control comprises the plan of an organization and all of the

coordinated methods and measures adopted with in a business to
safeguard its assets, check the accuracy and reliability of its accounting
data, promote operational efficiency and encourage adherence to
prescribed managerial policies.

This definition possibly is broader than the meaning sometimes attributed to the term. It
recognizes that a system of internal control extends beyond those matters that relate directly to the
function of the accounting and finance departments. Such a system might include budgetary
control, standard costs, periodic operating reports, statistical analysis and the dissemination
thereof, a training program designed to aid personnel in meeting their responsibilities, and an
internal audit staff to provide additional assurance to management as to the adequacy of its
outlined procedures and the extent to which they are being effectively carried out. It properly
comprehends activities in other fields as, for example, time and motion studies that are an
engineering nature and use of quality control through a system of inspection, which fundamentally
is production function. This is an extremely useful definition of internal control, giving us an
understanding of the number and variety of means open to management to control the actions of
its employees.
Internal control extends beyond the accounting and financial functions. Its scope is organization
wide and touches all activities of the organization. It includes the methods by which management
delegate authority and assigns responsibility for such functions as selling, purchasing, accounting,
and production. Internal control also includes the program for preparing, verifying and distributing
to various levels of supervision those reports and analyses that enable executives to maintain
control over the variety of activities and functions that constitute a large enterprise. The use of
budgetary techniques, production standards, inspection laboratories, time and motion studies, and
employee training programs involve engineers and many other technicians far removed from

42
accounting and financial activities, yet all of these devises are part of the mechanism now
conceived as a system of internal control.

4.2 Objectives of Internal Control System

The objectives of the internal control system are determined by the management keeping in view
its specific requirements that in turn depend on the nature of the enterprise, volume of operation
etc.
Among internal control system objectives, the following are the common ones:
1) To adhere to policies and procedures laid down by management.
2) To safeguard assets.
3) To ensure that the enterprise is conducting in an orderly and efficient manner.
4) To prevent and detect fraud and error.

To accomplish these objectives, management needs an adequate and reliable system of internal
control, for which management bears the primary and sole responsibility.
To the external auditors, internal control is of equal importance. The quality of the internal
controls enforces, more than any factor, and determines the pattern of their examination. Thus,
both auditors and management need a system of internal control to perform their respective
functions. However, the auditors’ objective for internal control is not the same as management’s.
The external auditors’ objective in their study and evaluation of the system of internal control is to
determine the nature, extent and timing of the audit work necessary to express an opinion as to the
fairness of the financial statements.

Systems of internal control vary significantly form one organization to the next. The specific
control features in any system depend upon such factors as size, organizational structure, and
nature of operations and objectives of the organization for which it was designed.

An auditor obtains information about internal control and uses that information as a basis for audit
planning. The auditor considers internal control by first obtaining an understanding of internal
control, which is then used to initially assess control risk. When the auditor’s control risk
assessment is below maximum, the auditor considers how those results affect planned detection
risk and substantive testing. The following are reasons for studying internal control.
 To be satisfied that sufficient, competent evidence is available to support the audit of
financial statement
 To identify potential material misstatement
 To assess control risk for each objective, which affect planned detection risk and planned
audit procedures
 Allow the auditor to design effective test of financial statement balances and analytical
procedures.
4.3 Scopes and Types of Internal Controls
The system of internal control involves the plan of organization and various other methods and
procedures. The plan of organization refers to the organizational structure and the method of
assigning authorities and responsibilities. Appropriate plan of organization is significant for
effective operation of the entire internal control system. Similarly, proper authorities and
responsibilities can be allocated in such a manner that no single person has control over all the
phases of any significant transactions. This minimized the possibilities of errors and frauds.
The plan of organization refers to the study of authority, responsibilities and duties among
members of an organization. A well-designed organization plan is a first step to assure that
transactions are executed in conformity with company polices, to enhance the efficiency of
operations to safeguard assets, and to promote the reliability and timely preparation of accounting
data. These objectives may be achieved in large part through adequate separation of responsibility
43
for initiation of approval of transactions, custody of assets and record keeping. When accounting
and custodial departments are relatively independent, the work of each department serves to verify
the accuracy of the work of the other. Periodic comparison should be made for accounting records
and physical assets on hand. Investigation as to the cause of any discrepancy will uncover
weakness either in the procedures for safeguarding assets or in the procedures to maintain the
related accounting records. If the accounting records were not independent of the custodial
department, the records could be manipulated to conceal waste, loss or theft of the related assets.

An internal control system has a wide coverage that extends beyond those matters, which relate
directly to the functions of the accounting system. From this angle, internal control can be divided
into two broad categories, accounting and administrative controls.

Auditors are primarily interested in internal control of an accounting nature, those controls bearing
directly upon the dependability of accounting records and the financial statements. For example,
preparation of monthly bank reconciliation by an employee not authorized to issue checks or
handle cash is an internal accounting control that increases the probability that cash transactions
are presented fairly in the accounting records and financial statements. Some internal controls
have no bearing on the financial statements and consequently are not of direct interest to
independent public accountant. Controls of this nature are often referred to as administrative
controls. Management is interested in maintaining strong internal control over, factory operations
and sales activities as well as over accounting and financial functions. Accordingly, management
will establish administrative controls, to provide operational efficiency and adherence to
prescribed policies in all departments of the enterprise.

Statement of Auditing Standards states that administrative control includes, but not limited to the
plan of organization and the procedures and records that are concerned with the decision processes
leading to management’s authorization of transactions. Such authorization is a management
function directly associated with the responsibility for achieving the objectives of the organization
and is the starting point for establishing accounting control of transactions.
Accounting control comprises the plan of organization and procedures and records that are
concerned with the safeguarding of assets and the reliability of financial records and consequently
are designed to provide reasonable assurance that:
 Transactions are executed in accordance with management’s general or specific
authorization.
 Transactions are recorded as necessary to permit preparation of financial statements in
conformity with generally accepted accounting principles or any other criteria applicable
to such statement and to maintain accountability to assets.
 Access to assets is permitted only in accordance with management’s authorization.
 The recorded accountability for assets is compared with the existing assets at reasonable
intervals and appropriate action is taken with respect to any differences.
Both accounting and administrative controls are derived form the organization’s policies
established by management, they are the means by which company policies are satisfactorily
accomplished. Therefore, auditors should be aware of these policies and review them in terms of
their impact on internal control.
The accounting system must be able to measure the performance and efficiency of the
individual organizational units. An accounting system with this should include:
1. Adequate documentation
2. Chart of accounts
3. Manual of accounting policies an procedures
4. Financial forecasts
In general, accounting controls related to the accounting system are:
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 a) Executing of transaction in accordance with the management’s
authorization
b) Prompt recording of transaction in proper manner
c) Maintained accountability to safeguard assets
Accounting controls should further include:
 Proper segregation of duties relating to accounting function
 Rotation of duties
 Periodic reconciliation
 Checking the arithmetical accuracy of the records
 Maintenance of control accounts and preparation of periodic trial balance
 Approval and control of documents
 Comparison with external sources of information
 Comparison of the results of physical inspection of fixed assets, cash
investments and inventories
 Comparison of actual figures with budgets
Accounting controls, policies and procedures generally fall into:
 Segregation of duties
 Authorization of transactions
 Maintenance of adequate records and documents
 Accountability and safeguarding of assets
 Independent checks on performance
4.4 Components of Internal Control
Internal control varies significantly from one organization to the other, depending on such
factors as their size, nature of operations, and objectives. Internal controls of large-scale
organizations, however, have certain common characteristics tanned as components of
internal control. The five components of internal control are:

1. The control environments

2. Control activities

3. Risk assessments

4. The information (accounting) and communication

5. Monitoring

We will discuss each of them as follows:

1. The Control Environment - The control environment consists of actions, policies and
procedures that reflect the overall attitudes of top management, directors, and owners of the
entity about control and its importance to the entity. The auditors need to consider the
following to assess and understand the control environment.

 Integrity and ethical values - Are product of the entity's ethical (code of Conduct) and
behavioral values and how they are communicated and reinforced in practice.
Effectiveness of internal control depends directly on the integrity and ethical values
of the personnel who are responsible for creating, administering and monitoring
controls. It includes management action to remove or reduce incentive and
temptations that might prompt personnel to engage in dishonest, illegal or unethical
acts.

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  Commitment to competence - Competence is the knowledge and skill necessary to
accomplish tasks that define the individual's job. Employees should posses the skill
and knowledge essential to perform their job for that they might be ineffective if they
lack the necessary skill and knowledge. Thus, management should be committed to
hiring employees with appropriate level of education and experience, and providing
them with adequate supervision and trainings.

 Board of directors or audit committee participation - Control environment of an

organization is significantly influenced by the effectiveness of its board of directors
or the audit committee. Factors that bear on the effectiveness of the board or the
audit committee consists of the degree of its independence from the management, the
experience and the stature of its members, the extent to which it raises difficult
questions with the management and its interaction with external and internal auditors.

 Management philosophy and operating style - Management differ in both their

philosophy towards financial reporting and their attitudes towards taking business
risks. Some management aggressively emphasis on meeting or exceeding earning
projections in their financial reporting and they are willing to undertake activities of
high risk with respect of high return. Others are extremely conservative and risk
averse. Management's philosophy and operating style is also reflected in the way the
organization is managed. That is, whether control is in an informal way (face to face
contact between employees and management) or formal; the organization establishes
written policies, performance reports, and exception reports to control its various
activities.

 Organization structure - The entity's organizational structure defines the lines of

responsibility and authority that exists. By understanding the client's organizational
structure, the auditor can learn the management and functional elements of the
business and perceive how controls are carried out.

 Assignments of authority and responsibility - Personnel in an organization need to

have a clear understanding of their responsibilities and the underlying rules and
regulations that govern their actions. Therefore, management should develop
employee job descriptions and clearly define authority and responsibility within the
organization so that the control environment can be enhanced.

 Human resource policies and practices - The most important aspect of internal
control is personnel. If employees are competent and trustworthy, other controls can
be absent and reliable financial, reports will still result from the system, as honest and
efficient people are able to perform at high level even when there are a few other
controls to support them. Because of the importance of competent and trust worthy
personnel in providing effective control, the policies and practices by which persons
are hired, trained, oriented, evaluated plays a significant role.

2. Control Activities - are the policies and procedures, in addition to those included in the
other four components that help ensure that the necessary actions are considered to address
risks in the achievements of the entity's objectives. Although there are several such control
activities in an entity, they fall into the following five categories:

1. Adequate separation of duties

2. Proper authorization of transactions and activities

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 3. Adequate documents and records

4. Physical control over assets and records

5. Independent check on performance

Adequate separation of duties- the following four general guidelines for separation of duties
to prevent both frauds and errors are of significant importance to auditors:

 Separation of the custody of assets from accounting - The reason for not permitting
the person who has temporary or permanent custody of an asset to account for that
asset is to protect the firm against defalcation. When on person performs both
functions, there is an excessive risk of that person's disposing of that asset for
personal gain and adjusting the records to relief himself or herself of the
responsibility.

 Separation of authorization of transactions from the custody of related assets - It is

desirable to prevent persons who authorize transactions from having control over the
related assets. For instance, the same person should not authorize the payment of
vendor's invoice and sign checks in payment of the bill as this situation increases the
possibility of defalcations in the organization.

 Separation of operational responsibility form record keeping responsibility - If each

department or divisions in an organization are responsible for preparing its reported
performance, In order to ensure unbiased information, record keeping is typically
included in a separate department under the controller.

 Segregation of duties within electronic data processing - It is desirable to separate the

major functions within the electronic data processing to the extent possible. The
duties of system analysts, programmers, computer operations and data librarians
should be separated.

Proper authorization of transactions and activities - Every transaction should be

appropriately authorized if controls are to be satisfactory. If any person in an organization
acquires and expends assets at will, would result in complete chaos. Authorization can be
either general or specific and is different from approval. Authorization is a policy decision
for either a general class of transactions or specific transactions. Approval is the
implementation of management's general authorization decisions. For instance, assume that
management sets a policy authorizing ordering of raw materials when there is less than one-
months supply on hand (i.e. general authorization). When the responsible department orders
raw materials the clerk responsible for maintaining the perpetual record approves the order to
indicate that the authorization policy has been met.

Adequate documents and records - documents and records are the physical objects upon
which transactions are entered and summarized. Documents perform the function of
transmitting information throughout the client's organization and between different
organizations. The documents must be adequate to reasonable assurance that all assets are
properly controlled and all transactions correctly recorded.

Physical control over assets and records - are those controls that provide physical security
over both records and other assets. Activities that safeguard assets include maintaining
control at all times over unissued pre-numbered documents, as well as other journals and
ledgers, and restricting access to computer programmers and data file. Only authorized
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persons should have access to company's valuable assets. Direct physical access to assets
may be controlled through the use of safes, locks, fences, and guards. Improper indirect
access to assets, generally accomplished by falsifying financial records, must also be
prevented. Periodic comparisons should be made between accounting records and the
physical assets on hand to detect the waste, loss or theft of the related assets.

Independent check on performance - It is continuous and careful review of the other four
control activities (i.e. an internal verification). The need for independent checks arises
because personnel are likely to forget or intentionally fail to follow procedures, or become
careless unless come one observes and evaluates their performance. An essential
characteristic of the persons performing internal verification procedure is independence from
the individuals originally responsible for preparing the data.

3. Risk assessment - Management should carefully identify and analyze the factors that
affect the risk that the organization's objectives will not be attained, and then attempt to
manage those risks. The scope of the management's risk assessment is comprehensive in that
it involves considerations of all the factors that affect the organization's objectives. Auditors
are concerned only with those risks associated with the objective of reliable financial
reporting threats to preparing financial statements in accordance with generally accepted
accounting principles. The following factors might be indicatives of increases risk of
financial reporting for an organization:

 Changes in the organization's regulatory or operating environment and personnel

 Implementations of new or modified information systems and corporate

restructurings.

 Changes in technology affecting production process and information systems

 Introductions of new lines of business, products or processes

 Rapid growth of the organization and expansion or acquisition of foreign operations.

 Adoption of new accounting principles or changing in accounting principles.

4. Information and communication - The purpose of an entity's accounting information and

communication system is to identify, assemble, classify, analyze, record and report the
entity's transactions and to maintain accountability for the related assets. An accounting
information and communication has several subcomponents, typically made up of classes of
transactions such as sales, sales returns, collections, acquisitions and so forth. For each class
of transaction the system must satisfy all of the six transaction- related audit objectives. For
instance the sales accounting system should be designed to assure that all shipment of goods
by a company are recorded as sales (completeness and accuracy objectives) and reflected in
the financial statements in the proper period (timing audit objective).

5. Monitoring - Monitoring activities deals with ongoing or periodic assessment of the

quality of internal control performance by management to determine that controls are
operating as intended and whether any modifications are necessary. Ongoing monitoring
activities include regularly performed supervisor and management activities such as
continuous monitoring of customer complaints, or reviewing the reasonableness of
management reports. Information for assessment and modification comes from a variety of
sources including studies of existing internal controls, internal auditor reports, exception

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reports on control activities, reports by regulatory agencies, and feedback from operation
personnel and complaints from customers.

4.5 Documentation of the Understanding

Three commonly used methods of documenting the understanding of internal control are
narratives, flow chart, and internal control questioners
1. Narrative is a written description of client’s internal control system. A proper narrative of an
accounting system and related control includes four characteristics;
 The description should state where customer order come from and how sales invoice are
generated
 All processes that takes place
 The dispossion of every document and record in the system
 An indication relevant to the assessment of control risk.
2. Flow Chart: an internal control flowchart is a symbolic, diagrammatical representation of the
client’s document and their sequential flow in the organization. An adequate flowchart includes
the four characteristics identified for narrative. Flow chart is advantageous primarily because it
provides a concise overview of the clients system which is useful to the auditor as analytical tool
in evaluation. A well prepared flowchart aids in identifying inadequacy by facilitating a clear
understanding of how the system operates. For most uses, it is superior to narratives as a method
of communicating the characteristics of a system, especially to show adequate separation of duties
3. Internal Control Questionnaire: an internal control questioner asks a series of questions
about the control in each audit area as means of indicating to the audit aspect of internal control
that may be inadequate. In most cases, it is designed to require yes or no response, with no
response indicating potential internal control deficiencies. The primary advantages of using a
questioner are the ability to thoroughly cover each audit area responsible quickly at the beginning
of the audit. The primary disadvantage is that individual parts of the clients system are examined
with out providing an over all view
4.6 Internal Control and Auditors
Internal audit as we will study in some detail later is means of management control
mechanism established internally and arising out of need for verification, evaluation
and compliance of internal operation. It is designed for management internal purposes.
As such internal audit is part of the internal control system in the organization, while
at the same time internal audit (or auditor), is responsible for the surveillance of the
effectiveness of the internal control system and involves its weakness and strength. As
mentioned earlier, the external auditor’s interest in internal control is in order to help him
determine the extent of reliability of organization’s results, and effectiveness of control of its
operations. To this end, he reviews the internal control (a) to understand the existing control
systems and procedures, (b) to evaluate their adequacy in fulfilling internal control objectives, by
identifying strengths and weaknesses. It is worth noting here that the study and review of internal
control is part of the independent auditor’s standard of fieldwork. He accomplishes this objective
through:
(a) Internal control questionnaire
(b) Interview
(c) Testing (compliance test)
(d) Study of organization charts, manuals and procedures.

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 Through compliance testing, he tries to identify weaknesses. If the compliance test proves to be
reliable it decreases the need for substantive test or vice versa too. The compliance test determines
if internal control systems and procedures are actually present and effective, and thus establishes
the congruence in the procedures of system. It must be distinguished that there is preliminary
review as well as extensive review, one that goes during the examination process.

4.7Internal Auditing
Internal auditing is a service function established within an organization to examine and evaluate
its activities. Internal audits may focus on financial reporting (financial audits); compliance with
policies, procedures, laws, or regulations (Compliance audits); fraud detection (fraud audits); or
operational efficiency and effectiveness (operational audits). The following diagram shows the
different components clearly

Internal Auditing

Financial Compliance Fraud Operational

Auditing Auditing Auditing Auditing

ting
Most internal audit staffs engage in all of these endeavors. To guide the practice of internal
auditing, the Institute of Internal Auditors has established general and specific standards. Although
not enforceable in the same sense as the AICPA auditing and attestation standards, they do
provide helpful guidance for the internal auditor concerning such maters as maintaining necessary
independence, required proficiency, audit scope, performing the audit, and administering the
internal audit function. Since the other types of auditing are discussed before, we will briefly
discuss operational auditing as follows

Operational Audit, as a subset of internal auditing, reviews an entity's activities for efficiency and
effectiveness and may evaluate any type of activity at any level within the organization. Unlike
financial auditing, operational auditing focuses on activities rather than financial statement
assertions. The audited activates may be related to a function (e.g., why is ABC plant producing a
high percentage of defective parts?). The overall objective, common to all operational audits, is
maximizing organizational welfare.

Management auditing is a subset of operational auditing that attempts to measure the effectiveness
with which an organizational unit is administered, and that concentrates more on effectiveness
than on efficiency. Efficiency may be viewed as an input measure that relates to cost control and is
concerned with the performance of recurring functions at a minimum of cost to the entity.
Effectiveness is output oriented; it is viewed as a measure of productivity in utilizing the firm's
resources and in terms of long-run profitability.

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The internal auditing function includes verification, evaluation and compliance of operations.
Among others the following are specifiable.
 Review and appraise internal control procedure
 Ascertain effectiveness and efficiency of operations
 Verify compliance to policies and procedures
 Ascertain reliability of data and documents
 Evaluate quality of performance
 Recommend improvements in better management controls.

The internal auditor can perform his work either through functional approach, operational
approach, or financial approach.

Responsibility and Authority

Internal auditing is a staff function; therefore, the auditor ideally is not in disposition of line
function. His position and place in the organization is determined by the scope of the function he
performs and extent of responsibility entrusted to him by management. It is desirable that he
should be placed as high as possible in the organization structure if he is truly to be of “service to
management “without intimidation, and be in position of surveillance over all the organization’s
activity.

The independence of the internal auditor again depends on his place in the organization, the extent
of responsibility and authority required for performing his function and the desire to enhance his
competence and independence in reporting to whom. Here, it must be appreciated that the desire
to have independence in the internal auditing function may not necessarily be attainable or be as
high as in the external auditing function. The matter of qualification for the internal auditor is also
dependent on the above factors. Of course, these factors are definitely much more clearly
demarcated in a large organization than in small.

Internal Audit Report

The end product of any audit work culminates in writing of an audit report, but unlike the external
auditor’s, the internal audit report is not standardized short-form in its contents consequently the
audit report of internal auditor requires lot of imagination and creativity with communicative
ability in its writing. The audit report should basically contain the following:
 Detail of purpose and scope of audit
 Description of tools and procedures of audit
 Findings, suggestion and opinions
 Recommendations.
It is important that verbosity, and negative criticism be avoided, while cooperation and
constructive suggestion should be emphasized.

Internal Auditing and External Auditing

There are similarities as well as differences between internal auditing and external auditing. The
similarities could be in terms of scope, and functions, tools and procedures. The differences lie
mainly in selection and employment, remuneration, qualification and independence.

There are arguments that propagate that if there is external auditing why there is a need for
internal auditing, or vice-versa. However, an in-depth understanding of the objectives and
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purposes of internal and external auditing can show that they should be rather complementary and
not competitive. If the internal auditing function is strong and wide, and performed by qualified
persons then the results of the operation of the organization can be reliable, which in turn assists in
decreasing the scope of audit work by the external auditor, and thus reduce the cost of external
audit fee? But the purposes of audit of the external and internal auditor are quite distinct and
cannot be a substitute for each other’s responsibility.

UNIT FIVE
AUDIT REPORT

5.1 Components of Audit Report

To enable users understand audit report, professional standards provide uniform wording for
auditor’s report. An audit report has to contain a minimum of the following seven parts.
1. Report title: - Auditing standard requires that the report be titled and that the title include
the word “independent”. For example, appropriate title would be “independent auditors
report”, “report of independent auditors”, or “independent accountant’s opinion”. The
requirement that the title includes the word independent is intended to convey to users that
the audit was unbiased in all aspects.
2. Audit Report Address: - the report is usually addressed to the company, its stockholders
or board of directors. In recent years, it has become customary to address the report to
stockholders to indicate that the auditor is independent of the company and the board of
directors.
3. Introductory Paragraph: - The first paragraph of the report does three things:-
b. It makes a simple statement that CPA firm has conducted an audit to distinguish it
from review or compilation.
c. It state financial statements that were audited in the wordings given by management
together with exact dates or periods
d. It shows that the statements are the responsibilities of managers and the auditors
work is to give an opinion to indicate that the selection of GAAP is up to managers.
4. Scope Paragraph: - The scope paragraph is a factual statement about what the auditor did
in the audit. This paragraph first states that the auditor followed generally accepted auditing
standards. The remainder briefly describes important aspects of an audit. The scope
paragraph states that the audit is designed to obtain reasonable assurance about whether the
statements are free of material misstatement. The inclusion of the word material conveys that
the auditor is responsible only to reach for significant misstatements not minor misstatements
that do not affect users decision. The use of the term reasonable assurance is intended to
indicate that an audit cannot be expected to completely eliminate the possibility that a
material misstatement will exist in the financial statement. In other words, an audit provides a
high level of assurances, but it is not a guarantee.

The remainder of the scope paragraph discusses the audit evidence accumulated and states
that the auditor believes that the evidence accumulated was appropriate for the circumstance
to express the opinion presented. The word test basis indicates that sampling is used rather
than an audit of every transaction and amount on the statement. The scope paragraph states
that the auditor evaluates the appropriateness of those accounting principles, estimates and
financial statements disclosures and presentations given.

5. Opinion Paragraph: The final paragraph in the standard report states the auditors
conclusions based on the results of the audit. This part of the report is so important that often
52
the entire audit report is referred to simply as the auditor’s opinion. The opinion paragraph is
stated as an opinion rather than as a statement of absolute fact or a guarantee. The intent is to
indicate that the conclusions are based on professional judgment. The phrase in our opinion
indicates that may be some information risk associated with the financial statement, even
though the statements have been audited.

The opinion paragraph is directly related to the first and the fourth generally accepted
auditing reporting standards. The auditor is required to state an opinion about financial
statement taken as a whole, including the conclusion about whether the company followed
Generally Accepted Accounting Principles. Financial statements are presented fairly when
the statements are in accordance with generally accepted accounting principles but that it is
also necessary to examine the substance of transactions and balances for possible
misinformation.
6. Name of CPA Firm: the name identifies the CPA firm or practitioner who performed the
audit. Typically, the firms name is used because the entire CPA firm has the legal and
professional responsibility to ensure that the quality of the audit meets professional
standards.
7. Audit Report Date: The appropriate date for the report is one on which the auditor has
completed the most important auditing procedures in the field. This date is important to users
because it indicates the last date of the auditor’s responsibility for the review of significant
events that occurred after the date of financial statements. For example, if the balance sheet is
dated December 31, 1998, and the audit report is dated march 6, 1999. This indicates that the
auditor has searched for material unrecorded transactions and events that occurred up to
March 6, 1999.

5.2 Kinds of Audit Opinion

There are five common types of auditor’s reports, each one presenting a different situation
encountered during the auditor’s work.
1. Standard Unqualified Opinion Report
2. Unqualified opinion with explanatory paragraph or modified wording
3. Qualified opinion Report
4. Adverse Opinion Report
5. Disclaimer of opinion Report
These different types of audit reports will be discussed in detail in the following sub units

5.2.1 Standard Unqualified Audit Report

This type of report is issued by an auditor when the financial statements presented are free
from material misstatements and are presented fairly in accordance with the Generally
Accepted Accounting Principles (GAAP), which in other words means that the company’s
financial condition, position, and operations are fairly presented in the financial statements. It
is the best type of report an auditee may receive from an external auditor. The standard
unqualified audit report is sometimes called a clean opinion because there are no
circumstances requiring a qualification or modification of the auditor’s opinion. The standard
unqualified report is the most common audit opinion. Sometimes, circumstances beyond the
client auditor’s control prevent the issuance of a clean opinion. However, in most cases,
companies make the appropriate changes to their accounting records to avoid a qualification
or modification by the auditor. The standard unqualified audit report is issued when the
following conditions have been met:
1. All statements- balance sheet, income statements or retained earnings and statements
of cash flow-are included in the financial statement.
2. The three general standards have been followed in all respects on the engagement
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 3. Sufficient evidence has been accumulated, and the auditor has conducted the
engagement in a manner that enables him or her to conclude that the three standards
of filed work have been met.
4. The financial statements are presented in accordance with Generally Accepted
Accounting Principles. This also means that adequate disclosures have been included
in the footnotes and other parts of the financial statements.
5. There are no circumstances requiring the additions of an explanatory paragraph or
modification of the wording of the report.
If any of the five requirements for the standard unqualified audit report are not met, the
standard unqualified report cannot be issued.

The following is an example of a standard unqualified auditor’s report on financial

statements as it is used in most countries, using the name ABC Company as an auditee’s
name:

INDEPENDENT AUDITOR’S REPORT

To: Stockholders
ABC Company, Inc.

We have audited the accompanying balance sheet of ABC Company, Inc. as of December 31,
2009 and the related statements of income, retained earnings, Balance sheet and cash flows
for the year then ended. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial statements based
on our audit.

We conducted our audit in accordance with auditing standards generally accepted in (the
country where the report is issued). Those standards require that we plan and perform the
audit to obtain reasonable assurance about whether the financial statements are free from
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 principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.

In our opinion, the financial statements referred to above presents fairly, in all material
respects, the financial position of the Company as of December 31, 2009, and the results of
its operations and its cash flows for the year then ended in accordance with accounting
principles generally accepted in (the country where the report is issued).

AUDITOR’S SIGNATURE
Auditor’s name and address

Date of the report’s issuance

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 5.2.2Unqualified Audit Report with Explanatory Paragraph or
Modified Wording

In certain situation, an unqualified audit report is issued, but the wording deviates from the
standard unqualified report. The unqualified audit report with explanatory paragraph or
modified wording meets the criteria of a complete audit with satisfactory results and financial
statements that are fairly presented, but the auditor believes it is important or is required to
provide additional information. The followings are the most important causes of the addition
of an explanatory paragraph or a modification in the wording of the standard unqualified
report.

1. Lack of consistent Application of GAAP

The second reporting standard requires the auditor to call attention to circumstances in which
accounting principles have not been consistently observed in the current period in relation to
the preceding period. Generally Accepted Accounting Principles require that change in
accounting principles or their method of application is to a preferable principle that the nature
and impact of the change be adequately disclosed. When a material change occurs, the
auditor should modify the report by adding an explanatory paragraph after the opinion
paragraph that discusses the nature of the change and points the reader to the footnotes that
discusses the change. An explanatory paragraph is required for both voluntary changes and
required changes due to a new accounting pronouncement

Explanatory paragraph because of change in accounting principles

Independent auditor’s opinion
(Same introductory, scope, and opinion paragraph as the standard report)

As discussed in the note to the financial statements, the company changed its method of
computing depreciation in 2009.

It is implicit in the explanatory paragraph in the above table that, the auditor concurs with the
appropriateness of the change in accounting principles. If the auditor does not so concur, the
change is considered a violation of Generally Accepted Accounting and his or her opinion
must be qualified
2. Consistency versus Comparability
The auditor must be able to distinguish between changes that affect consistency and those
that may affect comparability but don’t affect consistency. The following are examples of
changes that affect consistency and therefore require explanatory paragraph if they are
material
 Change in accounting principles, such as change from FIFO to LIFO inventory
valuation
 Changes in reporting entities, such as the inclusion of an additional company in
combined financial statements

55
  Correction of errors involving principles, by changing from an accounting principle
that is not generally acceptable to one that is generally acceptable, including
correction of the resulting error
Changes that affect comparability but not consistency and therefore need not be included in
the audit report includ the following
 Changes in estimates, such as a decrease in the life of an asset for depreciation
purposes
 Error corrections not involving principles such as a previous years mathematical error
 Variation in format and presentation of finical information
 Changes because of substantially different transactions or events, such as new
endeavors in research and development or the sales of subsidiary.
Items that materially affect the comparability of financial statements generally require
disclosure in the footnotes. A qualified audit report for inadequate disclosure may be required
if the client refuses to properly disclose the items
3. Substantial Doubt about Going Concern
Even though the purpose of an audit is not to evaluate the financial health of the business, the
auditor has a responsibility to evaluate whether the company is likely to continue as a going
concern. For example, the existence of one or more of the following factors causes
uncertainty about the ability of a company to continue as a going concern:
 Significant recurring operating losses or working capital deficiencies
 Inability of the company to pay its obligation as they come due
 Loss of major customers, the occurrence of uninsured catastrophes such as an
earthquake or flood, or unusual labor difficulties
 Legal proceedings, legislation, or similar matters that have occurred that might
jeopardize the entity’s ability to operate

When the auditor concluded that there is substantial doubt about the entity’s ability to
continue as a going concern, unqualified opinion with an explanatory paragraph is required,
regardless of the disclosure in the financial statement. The following table provides an
example in which there is substantial doubt about going concern.
Independent auditor’s opinion
(Same introductory, scope, and opinion paragraph as the standard report)

The accompanying financial statements have been prepared assuming that ABC Company
continues as going concern. As the discussion in the note to the financial statements, ABC
Company has suffered recurring losses from operations and has a net capital deficiency that
raises substantial doubt about the company’s ability to continue as a going concern.
Managements plan in regard to these matters are also described in the note. The financial
statements don’t include any adjustments that might result from the outcomes of this
uncertainty.

4. Auditors Agrees with a Departure from a Promulgated Principle

Sometimes the company’s departure from Generally Accepted Principles is acceptable, if
adhering to the principles would have produced a misleading result. In this case, the auditor
can issue Standard unqualified audit report with additional explanation for the change.
5. Emphasis of Matter
Under certain circumstance, the auditor may want to emphasis specific matters regarding the
financial statements even though he or she intends to express an unqualified opinion.
Normally, such explanatory information should be included in a separate paragraph in the
report. The followings are examples of explanatory information the auditor may think should
be expressed: existence of significant related party transactions, important events occurring
56
subsequent to the balance sheet date, the description of accounting matters affecting the
comparability of the financial statements with those of the preceding year and material
uncertainties disclosed in the footnotes.
6. Reports involving Other Auditors
When an auditor relies on different auditors to perform part of the audit, which is common
when the client has several widespread branches or subdivisions, the principal audit firm has
three alternatives. Only the second one is an unqualified report with modified wording
1. Make no reference in the audit report: when no reference is made to the other
auditor, a standard unqualified opinion is given unless other circumstances require a
departure. This paragraph is typically followed when the other auditor audited an
immaterial portion of the statement, the other auditor is well known or closely
supervised by the principal auditor, or the principal auditor has thoroughly reviewed
the other auditor’s work. The other auditor is still responsible for his or her own
report and work in the event of lawsuit.
2. Make reference in the report: This type of report is called a shared opinion or
report. A shared unqualified report is appropriate when it is impractical to review the
work of the other auditor or when the portion of the financial statements audited by
the other CPA is material in relation to the whole.
3. Qualify the opinion: the principal auditor may conclude that a qualified opinion
is required. A qualified opinion or disclaimer, depending on the materiality is
required if the principal auditor is not willing to assume any responsibility for the
work of the other auditor. The principal auditor may also decide that a qualification is
required in the overall report if the other auditor qualified his or her portion of the
audit. Qualified opinion and disclaimers are discussed in the next subunit.

5.2.3 Qualified, Adverse and Disclaimer Audit Reports

There are circumstances where the conditions of unqualified audit report are not satisfied.
When these conditions are not satisfied, the auditor issues an opinion other than unqualified
audit report. The three conditions requiring departure from unqualified audit report are

1. The scope of the audit has been restricted: when the auditor has not accumulated
sufficient evidence to conclude whether financial statements are stated in accordance with
GAAP, scope restriction exists. The scope restrictions can be caused by the client or
circumstances beyond the client or the auditor. An example of client restriction is
management’s refusal to permit the auditor to confirm material receivables or to physically
examine inventory. An example of restriction caused by circumstances is when the
engagement is not agreed on until after the client year end. It may not be possible to
physically observe inventories, confirm receivables or perform other important procedures
after the balance sheet date
2. Financial statements have not been prepared in accordance with generally accepted
accounting principles. For example, if the client insists on using replacement costs for fixed
or value inventory at selling price rather than historical cost, departure form unqualified
report is required.
3. The auditor is not independent: when any of the rules of the code of professional
conduct related to independence you have discussed in unit two are violated, the auditor is
said to be dependent
When any of the three conditions requiring a departure from unqualified report exists and is
material, a report other than unqualified report must be issued. Three main types of audit
reports are issued under this condition:: Qualified, Adverse opinion, and Disclaimer of
opinion.
1. Qualified Opinion Report

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A Qualified Opinion report is issued when the auditor encountered one of the two types of
situations which do not comply with generally accepted accounting principles, however, the
rest of the financial statements are fairly presented. This type of opinion is very similar to an
unqualified or “clean opinion”, but the report states that the financial statements are fairly
presented with a certain exception which is otherwise misstated. The two types of situations
which would cause an auditor to issue this opinion over the unqualified opinion are:
 Deviation from GAAP – this type of qualification occurs when one or more areas of
the financial statements do not conform with GAAP (e.g. are misstated), but do not
affect the rest of the financial statements from being fairly presented when taken as a
whole. Examples of this include a company dedicated to a retail business that did not
correctly calculate the depreciation expense of its building. Even if this expense is
considered material, since the rest of the financial statements do conform with GAAP,
then the auditor qualifies the opinion by describing the depreciation misstatement in
the report and continues to issue a clean opinion on the rest of the financial
statements.

 Limitation of Scope - this type of qualification occurs when the auditor could not
audit one or more areas of the financial statements, and although they could not be
verified, the rest of the financial statements were audited and they conform with
GAAP. Examples of this include an auditor not being able to observe and test a
company’s inventory of goods. If the auditor audited the rest of the financial
statements and is reasonably sure that they conform with GAAP, then the auditor
simply states that the financial statements are fairly presented, with the exception of
the inventory which could not be audited.
The wording of the qualified report is very similar to the unqualified opinion, but an
explanatory paragraph is added to explain the reasons for the qualification after the scope
paragraph but before the opinion paragraph. The introductory paragraph is left exactly the
same as in the unqualified opinion, while the scope and the opinion paragraphs receive a
slight modification in line with the qualification in the explanatory paragraph.
The scope paragraph is edited to include the following phrase in the first sentence, so that the
user may be immediately aware of the qualification. This placement also informs the user
that, except for the qualification, the rest of the audit was performed without qualifications:
“Except as discussed in the following paragraph, we conducted our audit...”

The opinion paragraph is also edited to include an additional phrase in the first sentence, so
that the user is reminded that the auditor’s opinion explicitly excludes the qualification
expressed. Depending on the type of qualification, the phrase is edited to either state the
qualification and the adjustments needed to correct it or state the scope limitation and that
adjustment could have but not necessarily been required in order to correct it.

For a qualification arising from a deviation from GAAP, the following phrase is added to the
opinion paragraph, using the depreciation example mentioned above:

“In our opinion, except for the effects of the Company’s incorrect determination of
depreciation expense, the financial statement referred to in the first paragraph
presents fairly, in all material respects, the financial position of…”

For a qualification arising from a scope limitation, the following phrase is added to the
opinion paragraph, using the inventory example mentioned above:
“In our opinion, except for the effects of such adjustments, if any, as might have been
determined to be necessary had we been able to perform proper tests and procedures
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 on the Company’s inventory, the financial statement referred to in the first paragraph
presents fairly, in all material respects, the financial position of…”

Due to the phrases added to the scope and opinion paragraphs, many refer to this report as the
Except-For Opinion.

2. Adverse Opinion Report

An Adverse Opinion is issued when the auditor determines that the financial statements of an
auditee are materially misstated and, when considered as a whole, do not conform with
GAAP. It is considered the opposite of an unqualified or clean opinion, essentially stating
that the information contained is materially incorrect, unreliable, and inaccurate in order to
assess the auditee’s financial position and results of operations. Investors, lending
institutions, and governments very rarely accept an auditee’s financial statements if the
auditor issued an adverse opinion, and usually request the auditee to correct the financial
statements and obtain another audit report.

Generally, an adverse opinion is only given if the financial statement pervasively differs from
GAAP. An example of such a situation would be failure of a company to consolidate a
material subsidiary.

The wording of the adverse report is similar to the qualified report. The scope paragraph is
modified accordingly and an explanatory paragraph is added to explain the reason for the
adverse opinion after the scope paragraph but before the opinion paragraph. However, the
most significant change in the adverse report from the qualified report is in the opinion
paragraph, where the auditor clearly states that the financial statements are not in accordance
with GAAP, which means that they, as a whole, are unreliable, inaccurate, and do not present
a fair view of the auditee’s position and operations.

“In our opinion, because of the situations mentioned above (in the explanatory
paragraph), the financial statements referred to in the first paragraph do not present
fairly, in all material respects, the financial position of…”

3. Disclaimer of Opinion Report

A Disclaimer of Opinion, commonly referred to simply as a Disclaimer, is issued when the
auditor could not form, and consequently refuses to present, an opinion on the financial
statements. This type of report is issued when the auditor tried to audit an entity but could not
complete the work due to various reasons and does not issue an opinion.
Auditing Standards provide certain situations where a disclaimer of opinion may be
appropriate:
 A lack of independence, or material conflict(s) of interest, exist between the auditor
and the auditee
 There are significant scope limitations, whether intentional or not, which hinder the
auditor’s work in obtaining evidence and performing procedures
 There is a substantial doubt about the auditee’s ability to continue as a going concern
or, in other words, continue operating
 There are significant uncertainties within the auditee

Although this type of opinion is rarely used, the most common examples where disclaimers
are issued include audits where the auditee willfully hides or refuses to provide evidence and
information to the auditor in significant areas of the financial statements, where the auditee is
facing significant legal and litigation issues in which the outcome is uncertain (usually
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government investigations), and where the auditee has going concern issues (the auditee may
not continue operating in the near future). Investors, lending institutions, and governments
typically reject an auditee’s financial statements if the auditor disclaimed an opinion, and will
request the auditee to correct the situations the auditor mentioned and obtain another audit
report.

A disclaimer of opinion differs substantially from the rest of the auditor’s report because it
provides very little information regarding the audit itself, and includes an explanatory
paragraph stating the reasons for the disclaimer. Although, the report still contains the
letterhead, the auditee’s name and address, the auditor’s signature and address, and the
report’s issuance date, every other paragraph is modified extensively, and the scope
paragraph is entirely omitted since the auditor is basically stating that an audit could not be
realized.

In the introductory paragraph, the first phrase changes from “We have audited” to “We were
engaged to audit” in order to let the user know that the auditee commissioned an audit, but
does not mention that the auditor necessarily completed the audit. Additionally, since the
audit was not completely and/or adequately performed, the auditor refuses to accept any
responsibility by omitting the last sentence of the paragraph. The scope paragraph is omitted
in its entirety since, effectively, no audit was performed. Similar to the qualified and the
adverse opinions, the auditor must briefly discuss the situations for the disclaimer in an
explanatory paragraph. Finally, the opinion paragraph changes completely, stating that an
opinion could not be formed and is not expressed because of the situations mentioned in the
previous paragraphs. The following is a draft of the three main paragraphs of a disclaimer of
opinion because of inadequate accounting records of an auditee, which is considered a
significant scope limitation:

We were engaged to audit the accompanying balance sheet of ABC Company, Inc.
(the “Company”) as of December 31, 2009 and the related statements of income and
cash flows for the year then ended. These financial statements are the responsibility
of the Company's management.

The Company does not maintain adequate accounting records to provide sufficient
information for the preparation of the basic financial statements. The Company’s
accounting records do not constitute a double-entry system which can produce
financial statements.

Because of the significance of the matters discussed in the preceding paragraphs, the
scope of our work was not sufficient to enable us to express, and we do not express,
an opinion of the financial statements referred to in the first paragraph.

5.3 Materiality and Audit Report

A misstatement in the financial statements can be consider material if knowledge of the
misstatement would affect a decision of a reasonable user of the statements. Materiality is an
essential consideration in determining the appropriate types of report for a given set of
circumstances. For example, if a misstatement is immaterial relative to the financial
statements of the entity for the current period, it is appropriate to issue an unqualified report.
A common instance is the immediate expensing of office supplies rather than carrying the
unused portion in inventory because the amount is significant. The situation is totally
different when the amounts are of such significant that the financial statements are materially
affected as a whole. In these circumstances, it is necessary to issue a disclaimer of opinion or
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an adverse opinion, depending on the nature of the misstatement. In situation of lesser
materiality a qualified opinion is appropriate.
Three levels of materiality are used for determining the type of opinion to issue

1. Amounts are Immaterial: When a misstatement in the financial statement exists but
is unlikely to affect the decision of a reasonable user, it is considered to be
immaterial. Unqualified opinion is therefore appropriate. For example, assume that
management recorded unexpired insurance as an asset in the previous year and
decides to expense it in the current year to reduce record keeping costs; management
has failed to follow GAAP but if the amounts are small, the misstatement would be
immaterial and standard unqualified audit report would be appropriate.
2. Amounts are material but don’t overshadow the financial statements as a whole:
The second level of materiality exists when a misstatement in the financial statement
would affect a user’s decision but the overall statements are still fairly stated and
therefore useful. For example, knowledge of a large misstatement in fixed assets
might affect a user’s willingness to loan money to accompany if the asset were the
collateral. When the auditor concludes that a misstatement is material but doesn’t
overshadow the financial statements as a whole, a qualified opinion using except for
is appropriate.
3. Amounts are so material or so pervasive that overall fairness of the statements is
in question. The highest level of materiality exists when users are likely to make
incorrect decisions if they rely on the overall financial statements when the highest
level of materiality exists, the auditor must issue either a disclaimer of opinion or an
adverse opinion, depending on which conditions exist.

The following table summarizes the relation ship between materiality and type of opinion
issued
Materiality level Significance in terms of reasonable user
decision Type of opinion
Immaterial users decisions are unlikely to be affected Unqualified
User’s decisions are likely to be affected only if
the information in question is important to the
specific decisions being made. The overall
Material financial statement are presented fairly Qualified
Most or all users decision based on the financial Disclaimer or
Highly material statements are likely to be significantly affected Adverse

Auditor’s Decision Process for Audit Reports

Auditors use a well defined process for deciding the appropriate audit report in a given set of
circumstances. The followings are steps followed:
1. Determine whether any condition exists requiring a departure from a
standard unqualified report: Auditors identify conditions as they perform the
audit and include information about any condition in the working paper as
discussion items for audit reporting. If non of these conditions exists, which is the
case in most audits, the auditor issue a standard unqualified audit report.
2. Decide the materiality for each condition: when a condition requiring a
departure from a standard unqualified opinion exists, the auditor evaluates the
potential effect on the financial statements. For departure from GAAP or scope
restriction, the auditor decides among immaterial, material, and highly material.
All other conditions, except for lack of auditor’s independence, require only a
distinction between immaterial and material. The materiality decision is a difficult
61
 one requiring considerable judgment. For example, assume that there is a scope
limitation in auditing inventory. It is difficult to assess the potential misstatement
of an account that the auditor doesn’t audit.
3. Decide the appropriate type of report for the condition, given the materiality
level: After making the first two decisions, it is easy to decide the appropriate type
of opinion by using a decision aid. The following table is an example for such an
aid

Conditions requiring an Level of Materiality

unqualified report with modified
wording or explanatory paragraph Immaterial Material
Accounting Principles not Unqualified with explanatory
consistently applied Unqualified paragraph
Unqualified with explanatory
Doubt about Going concern Unqualified paragraph
Unqualified with explanatory
Departure from GAAP Unqualified paragraph
Unqualified with explanatory
Emphasis of matter Unqualified paragraph
Unqualified with modified
Use of another auditor Unqualified wording

Level of Materiality
Conditions requiring departure from Material but not Material and
unqualified report Immaterial overshadow overshadow
Scope restricted by client or conditions Unqualified Qualified Disclaimer
Financial statements not prepared in
accordance with GAAP Unqualified Qualified Adverse
The auditor is not independent - Disclaimer -

Auditors often encounter situations involving more than one of the conditions requiring a
departure from an unqualified report or modification of the standard unqualified report. In
this circumstance, the auditor should modify his or her opinion for each condition unless one
has the effect of neutralizing the others. For example, if there is a scope limitation and a
situation in which the auditor is not independent, the scope limitation should not be revealed.
The following situations are examples when more than one modification should be included
in the report:
 The auditor is not independent and the auditor know that the company has not
followed GAAP
 There is a scope limitation and there is substantial doubt about the company’s ability
to continue as a going concern
 There is a substantial doubt about the company’s ability to continue as going concern,
and information about the cause of uncertainty is not adequately disclosed in a
footnote
 There is a deviation in the statements preparation in accordance with GAAP and other
accounting principles was applied on a basis that was not consistent with that of the
preceding year.

4. Write the Audit Report

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 Many readers interpret the number of paragraphs in the report as an important signal as to
whether the financial statements are correct. A three paragraph report originally indicates that
there are no exceptions in the audit. However, three paragraph reports are also issued when a
disclaimer of opinion is issued due to a scope limitation or for an unqualified shared report
involving other auditors. More than three paragraphs indicate some type of qualification or
requiring explanation. The table below summarizes the type of reports issued for the audit of
financial statements, the number of paragraphs for each type, the standard wording,
paragraph modified, and the location of additional paragraph.

Number of Standard wording Location of additional

Type of report paragraph paragraph modified paragraph
Standard
Unqualified Three None None
Unqualified with
Explanatory Four None After opinion
Qualified Four Opinion only Before opinion
Introductory and opinion
Disclaimer Three paragraph modified Before opinion
Adverse Four Opinion only Before opinion

UNIT SIX
AUDIT EVIDENCE
6.1. Nature of Evidence
Audit evidence is any information used by the auditor to determine whether the information
being audited is stated in accordance with the established criteria. The information varies
greatly in the extent to which it persuades the auditor whether the financial statements are
stated in accordance with Generally Accepted Accounting Principles. Evidence includes
information that is highly persuasive, such as the auditor's count of marketable securities, and
less persuasive information, such as response to questions of client employees.

6.2. The Audit Evidence Decision

A major decision facing every auditor is determining the appropriate types and amounts of
evidence to accumulate to be satisfied that the components of the client's financial statements
and the overall statements are fairly stated. This judgment is important because of the
prohibitive cost of examining and evaluating all available evidence. For example, in an audit
of financial statement, of most organizations, it is impossible for CPA firm to examine the
contents of all computer files or available evidence such as cancelled checks, vendors'
invoices, customer orders, payroll time cards, and the many other types of documents and
orders. The auditor's decision on evidence accumulation can be broken down into the
following four sub decisions.
1) Which audit procedure to use
2) What sample size to select for a given procedure
3) Which items to select from the population
4) When to perform the procedure
1. Audit Procedure: an audit procedure is the detailed instruction for the collection of audit
evidence that is to obtain at some time during the audit. In designing audit procedures, it is
common to spell them out in sufficiently specific to permit their use as instructions during
the audit. For example, the following is an audit procedure for the verification of cash
disbursements:

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  Obtain the cash disbursements journal and compare the payer name, amount, and date
on the cancelled checks with the disbursements journal
2. Sample size: Once an audit procedure is selected, it is possible to vary the sample size
from one to all the items in the population being tested. In the audit procedure above,
suppose 6,600 checks are recorded in the cash disbursement journal. The auditor may select
a sample size of 200 checks for comparison with the cash disbursement journal. The
decision of how many items to test must be made by the auditor for each audit procedure.
The sample size for any given procedure is likely to vary from audit to audit.
3. Items to select: After the sample size has been determined for an audit procedure, it is still
necessary to decide which items in the population to test. If the auditor decides, for
example, to select 200 cancelled checks fro population of 6,600 for comparison with the
cash disbursement journal, several deferent methods can be used to select the specific
checks to be examined. The auditor could (1) select a week and examine the first 200
checks (2) select the 200 checks with the largest amounts, (3) select the checks randomly,
or (4) select those checks that the auditor thinks are most likely to be in error. Or a
combination of these methods could be used.
4. Timing: Auditor of financial statements usually covers a period such as a year, and an
audit is usually not completed until several weeks or months after the end of the period.
The timing of audit procedures can therefore vary from early in the accounting period to
long after it has ended. In part, the timing decision is affected by when the client needs the
audit to be completed.

6.3. Persuasiveness of Evidence

The third standard of fieldwork requires the auditor to accumulate sufficient and competent
evidence to support the opinion issue. Because of the nature of the audit evidence and the
cost consideration of doing au audit it is unlikely that the auditor will be completely
convinced that the opinion is correct. However, the auditor must be persuaded that his/her
opinion is correct with a high level of assurance. By combining all evidence from the entire
audit, the auditor is able to decide when he/she is persuaded to issue and audit report.
The two determines of the persuasiveness of evidence are Competence and sufficiency,
which are taken directly from the third standard of fieldwork.
6.3.1. Competence: Competence of evidence refers to the degree to which evidence can be
considered believable or worthy of trust. If evidence is considered highly competent, it is a
great help in persuading the auditor that financial statements are fairly stated. For example, if
an auditor counted the inventory, that evidence would be more competent than if
management gave the auditor its own figure. In most cases, the term reliability of evidence is
being used synonymously with competence.
Competence of evidence deals only with the audit procedures selected. Competence can not
be improved by selecting a larger sample size or different population items. It can be
improved only by selecting audit procedures that contain a higher quality of one or more of
the following seven characteristics of the competent evidence: Relevance, independence of
provider, effectiveness of client's internal control, auditor's direct knowledge, qualification of
individuals proving the information, degree of objectivity, and timeliness.
1. Relevance: Evidence must pertain to or be relevant to the audit objective that the auditor
is testing before it can be reliable. For example, assume that the auditor is concerned that
a client is failing to bill customers for shipments (completeness objective). If the auditor
selected a sample of duplicate sales invoices and traced each to related shipping
document s, the evidence would not be relevant for the completeness objective and
therefore, would not be considered reliable evidence for that objective. A relevant
procedure would be to trace a sample of shipping documents to related duplicate sales
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 invoice to determine whether each had been billed. The second audit procedure is
relevant and the first is not because the shipment of goods is the normal criterion used for
determining whether a sale has occurred and should have billed. By tracing from
shipping, documents to duplicate sales invoices, the auditor can determine whether
shipment have been billed to customers. When the auditor traces from duplicated sales
invoices, to shipping documents, it is impossible to fined unbilled shipments.
Relevance can be considered only in terms of specific audit objectives. Evidence may be
relevant to one audit objective but not to a different one.
3. Independence of provider: Evidence obtained from a source outside the entity is more
reliable than that obtained from within. For example, external evidence such as
communication from banks, attorneys, or customers is generally considered more reliable
than answers obtained from inquiries of the client. Similarly, documents that originate
from out side the client's organization are considered more reliable than are those that
originate within the company and have never left the client's organization.
4. Effectiveness of client's internal control: When a client's internal controls are effective,
evidence obtained is more reliable than when they are weak. For example, if internal
control over sales and bills are effective, the auditor could obtain more competent
evidence from sales invoices and shipping documents than if the controls were
independent.
5. Auditor's direct knowledge: Evidence obtained directly by the auditor through physical
examination, observation, computation, and inspection is more competent than
information obtained indirectly. For example, if the auditor calculates the gross margin as
a percentage of sales and compares it with previous periods, the evidence would be more
reliable than if the auditor relied on the calculations of the controller.
6. Qualification of individuals providing the information: Although the source of
information is independent, the evidence will not be reliable unless the individual
providing it is qualified to do so. Therefore, communications from attorneys and bank
confirmations are typically more highly regarded than accounts receivable, confirmations
from persons not familiar with the business world. Also, evidence obtained directly by
the auditor may not be reliable if he/she lacks the qualification to evaluate the evidence.
7. Degree of Objectivity: Objective evidence is more reliable than evidence that requires
considerable judgment to determine whether it is correct. Examples, of objective
evidence includes confirmation of accounts receivables and bank balances, the physical
count of securities and cash, and adding (footing) a list of accounts payable to determine
whether it agrees with the balance in the general ledger. Example of subjective evidence
include a letter written by clients attorneys discussing the likely outcome of outstanding
lawsuit against the client, observation obsolescence of inventory during physical
examination, and inquires of the credit manager about the collectibility of non current
account receivable when the reliability of subjective evidence is began evaluated, the
qualification of the person providing the evidence are important.
8. Timeliness: The timeliness of audit evidence can refer either to when it is accumulated or
to the period covered by the audit. Evidence is usually more reliable for balance sheet
accounts when it is obtained as close to the balance sheet date as possible. For example,
the auditor's count of marketable securities on the balance sheet date would be more
reliable than the count two months earlier. For income statement accounts, evidence is
more reliable if there is a sample from the entire period under audit rather than from only
a part of the period.

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6.3.2. Sufficiency: The quantity of evidence obtained determines its sufficiency. Sufficiency
of evidence is measured primarily by the sample size the auditor selects. For a given audit
procedure, the evidence obtained from a sample size of 200 would ordinarily be more
sufficient than from a sample of 100. Several factors determine the appropriate sample size in
audit.
The two most important ones are:
1. The auditor's expectation of misstatement
2. Effectiveness of internal control
If the auditor concludes that there is a high likelihood of obsolete inventory because of the
nature of the client's industry, the auditor would sample more inventories for obsolescence in
an audit such as this than one where the likelihood of obsolescence was low. Similarly, if the
auditor concludes that the client's internal control is effective, over fixed assets, a smaller
sample size in the audit of acquisition of fixed assets is warranted.
In addition to sample size, the individual items tested affect the sufficiency of evidence.
Samples containing population items with larger dollar values, items with a large likelihood
of misstatement, and items that are representative of the population are usually considered
sufficient. In contrast, most auditors would usually consider samples insufficient that contain
only the largest dollar items from the population unless these items make up a large portion
of the total population amount.
Persuasiveness of evidence can be evaluated only after considering the combination of
competence and sufficiency, including the effects of the factors influencing competence and
sufficiency. A large sample of evidence provided by an independent party is not persuasive
unless it is relevant to the audit objective being tested. A large sample of evidence that is
relevant but not objective is not persuasive. Similarly, a small sample of only one or two
piece of highly competent evidence also typically lacks persuasiveness. The auditor must
evaluate the degree to which both competence and sufficiency, including all factors
influencing them, have been met when determining the persuasiveness of evidence.
Persuasiveness and cost: in making decisions about evidence for a given audit, both
persuasiveness and cost must be considered. It is rare when only one type of evidence is
available for varying information. The persuasiveness and cost of all alternatives should be
considered before selecting the best type or types. The auditor's goal is to obtain a sufficient
amount of competent evidence at the lowest possible total cost. However, cost is never an
adequate justification for omitting a necessary procedure or not gathering sample size.

6.4. Types of Audit Evidence

In making which audit procedures to use, the auditor can choose from seven broad categories
of evidence. These categories, called types of evidence, are listed below and defines are
discussed in this section.
1. Physical examination
2. Confirmation
3. Documentation
4. Observation
5. Inquiry of the client
6. Re-performance
7. Analytical Procedure
6.4.1. Physical Examination: Is the inspection or count by the auditor of tangible assets.
This type of evidence is most often associated with inventory and cash, but it is also
applicable to the verification of securities, notes receivable, and tangible fixed assets. The
distinction between the physical examination of assets, such as marketable securities and
cash, and the examination of documents such cancelled checks and sales documents, is
important for auditing purpose. If the object being examined, such as a sales invoices has no
66
inherent value, the evidence is called documentation. For example, before check is signed, it
is documented; after it is signed, it becomes an asset; and when it is cancelled, it becomes a
document again. Typically, physical examination of the checks can occur only while the
check is an asset. Physical examination, which is a direct means of verifying that an assets
actually exists (existence objective), is regarded as one of the most reliable and useful types
of audit evidence. Generally, physical examination is an objective means of ascertaining both
the quality and the description of the assets. In some case, it is also a useful method for
evaluating an asset's condition or quality. However, physical examination is not sufficient
evidence to verify that existing assets are owned by the client (rights and obligations
objective), and in many cases the auditor is not qualified to judge qualitative factors such as
obsolescence or authenticity (net realizable value objective). Also, proper valuation for
financial statement purpose usually cannot be determined by physical examination (accuracy
objective).
6.4.2. Confirmation: Describes the receipt of a written or oral response from an independent
third party verifying the accuracy of information that was required by the auditor. The
request is made to the client, and the client asks the independent third party to respond
directly to the auditor. Because the confirmation comes from sources independent of client,
they are a highly regarded and often used type of evidence. However, confirmations are
relatively costly to obtain and may cause some inconvenience to those asked to supply them.
Therefore, they are not used in every instance in which they are applicable. Because of the
high reliability of confirmations, auditors typically obtain written response rather than oral
ones when it is practical. Written confirmations are easier for supervisors to review, and they
provide better support if it is necessary to demonstrate that a confirmation was received.
Whether or not confirmations should be used depends on the reliability needs of the
situation as well as the alternative evidence available. Traditionally, confirmations are
seldom used in the audit of fixed asset additions because these can be verified adequately by
documentation and physical examination. Similarly, confirmations are ordinarily not used to
verify individual transactions between the organizations, such as sales transactions, such as
sale transactions, because the auditor can use documents for that purpose.
SAS 67 (AU 330) identifies three common types of confirmation used by auditors.
A Positive confirmation with a request with a request for information to be supplied by
the recipient. A positive confirmation means that the recipient is requested to return
confirmation in all circumstances. When the auditor does not receive a response to a positive
confirmation, it is common to send a second or third request and in some cases even request
the client to contact the independent third party and ask for a response to the auditor. If other
efforts failed, or are considered too costly, the auditor may be able to use different evidence
to satisfy the audit objective. This evidence is called alternate procedure.
Positive confirmation with the information to be confirmed includes on the form. This
type of confirmation is considered less reliable than the first one because the recipient may
sign the confirmation and return it without carefully examining the information
Negative confirmation. A negative confirmation means that the recipient is requested to
respond only when the information is incorrect. Because the confirmations are considered
significant evidence only when returned, negatives are considered less competent than
positive confirmations.
Note although confirmation is not required for any accounts other than account receivable,
this type of evidence is useful in varying many type of information. This major types of
information that are often confirmed, along with the source of confirmation are indicated as
follows.
Information Source
Cash in bank Bank
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 Accounts receivable Customers
Notes Receivable Maker
Owned inventory on Consignment Consignee
Accounts Payable Creditor
Notes Payable Lender
Advance from Customers Customer
Mortgage Payables Mortgager
Bonds Payable Bondholder
Shares Outstanding Register and transfer agent
Insurance Coverage Insurance company
Contingent Liabilities Bank, Lender and Client's legal counsel
Bond Issuance agreements Bondholder
Collateral held by Creditors Creditor

To be considered reliable evidence, confirmations must be controlled by the auditor from the
time they are prepared until they are returned. If the clients controls the preparation of the
confirmation, does the mailing, or, receives the responses, the auditor has lost control and
with it independence; thus, the reliability of the evidence is reduced.
6.4.3. Documentation: Documentation is the auditor's examination of the client's documents
and records to substantiate the information that is or should be included in the financial
statements. The documents examined by the auditor are the records used by the client to
provide information for conducting its business in an organized manner. Because each
transaction in the client's organization is normally supported by at least one document, there
is a large volume of this type of evidence available. For example, the client often retains a
customer order, a shipment document, and duplicate sales invoices for each sales transaction.
These same documents are useful evidence for verification by the auditor of the accuracy of
the client's records for sales transaction. Documentation is form evidence widely used in
every audit because it is usually readily available to the auditors at a relatively lower cost.
Some times it is the only reasonable type of evidence available.
Documents can be conveniently classified as internal and external.
An internal documents is one that has been prepared and used within the client's organization
and is retained without ever going to outside party such as a customer or a vendor. Examples
of internal documents include duplicate sales invoices, employees' time reports, and
inventory receiving reports.
An external document is one that has been in the hands of some one outside the client's
organization who is a party to the transaction being documented, but which is either currently
in the hands of the client or readily accessible. Example of this type of external documents
vendors' invoices, cancelable notes payable and insurance policies.
The primary determinants of the auditor's willingness to accept a document as reliable
evidence is whether it is internal or external and, when internal, whether it was created and
processed under condition of good internal control . Internal documents created and
processed under condition of weak internal control may not constitute reliable evidence.
Because external documents have been in the hands of both the client and another party to
the transaction, there is some indication that both members are in agreement about the
information and the condition stated on the documents. Therefore, external documents are
considered more reliable evidence than internal once.
When auditors use documentation to support recorded transactions or amounts it is often
called Vouching.

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6.4.4. Observation: Is the use of the senses to assess certain activities. Throughout the audit,
there are many opportunities to exercise sight, hearing, touch, and smell to evaluate a
wide range of items. For example, the auditor may tour the plant to obtain a general
impression of the client's facilities, observe whether equipment is rusty to evaluate
whether it is obsolete, and which watch individuals perform accounting tasks to
determine whether the person assigned responsibility is performing it. Observation is
rarely sufficient by itself because, there is a risk that the client personnel involved in
those activities are aware of the auditor's presence. Therefore, they may perform their
responsibilities in accordance with company policy, but resume normal activities once the
auditor is not incite.
6.4.5. Inquiries of the client: Inquiry is the obtaining of written or oral information from
the client in response to questions from the auditor. Although considerable evidence is
obtained from the client through inquiry, it usually cannot be regarded conclusive
because it is not from an independent source and may be biased in the client's favor.
Therefore, when the auditor obtains evidence through inquiry, it is normally necessary to
obtain further corroborating evidence though other procedures.
6.4.6. Re-performance: As the word implies, re-performance involves rechecking a sample
of the computations and transfer of information made by the client during the period
under audit. Rechecking of computation consists of testing the client's arithmetical
accuracy. It includes such procedures as extending sales invoices and inventory, adding
journals and subsidiary records, and checking the calculation of depreciation expense and
prepaid expenses. Rechecking of transparence of information consists of tracing amounts
to be confident that when the same information is included in more than one place, it is
recorded at the same amount each time.
Analytical Procedures: Analytical procedures are defined by SAS (AU 329) as evaluations
of financial information made by a study of relationships among financial and non financial
data…..involving comparisons of recorded amounts to expressions developed by auditors. It
uses comparisons and relationships to assess whether account balances or other data appears
reasonable. An example is comparing the gross margin percent in the current year with the
preceding years. The auditing standard board has concluded that analytical procedures are so
important that they required during the planning and completion phase on all audit.
Importance of Analytical Procedures
1. Enable to understand client's industry and business
Generally, an auditor considers knowledge and experience about a client company obtained
in prior years as a starting point for planning the audit for the current year. By conducting
analytical procedures in which the current year's unaudited information is compared with
prior years' audited information, changes are highlighted. The changes represent important
trends or specific events, all of which will influence audit planning.
For example, a decline in gross margin percentages overtime may indicate increasing
competition in the comp65any's market area, and the need to consider inventory pricing more
carefully during the audit. Similarly, an increase in the balance in fixed assets may indicate a
significant acquisition that must be reviewed.
2. Enable to assess the entity's ability to continue as going concern
Analytical procedures are often useful as an indication that the client company encountering
severe financial difficulty. The likelihood of financial failure must be considered by the
auditor in the assessment of audit related risks, as well as in connection with management's
use of the ongoing concern assumptions in preparing the financial statements. For example, if
a higher than normal ratio of long-term debt to net worth is combined with a lower than
average ratio, of profits to total assets, a relatively high risk of financial failure may be
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indicated. Not only would such condition affect the audit plan, they may indicate that
substantial doubt exists about the entity's ability to continue as going concern, which could
require a report modification.
3. It indicates the presence of possible misstatement in the financial statements
Significant unexpected difference between the current year's unaudited financial data and
other data used in comparisons are commonly called unusual fluctuations. Unusual
fluctuations occur when significant difference are not expected but do exist or when
significant differences are expected but do not exist. In either case, one of the possible
reasons for unusual fluctuations is the presence of an accounting misstatement. Thus, if the
unusual fluctuation is large, the auditor must determine the reason for it and must be satisfied
that the cause is a valid economic event and not a misstatement. For example, in comparing
the ratio of the allowance for uncollectible accounts receivable to gross accounts receivable,
with that of the previous year, suppose that the ratio had decreased while, at the same time,
accounts receivable turnover also decreased. The combination of these two pieces of
information would indicate a possible understatement of the allowance. This aspect of
analytical process is often called attention directing because it results in more detailed
procedures in the specific audit areas where misstatements might be found.
4. Reduced Detailed audit test: When the analytical procedure reveals no unusual
fluctuations, the implication is that the possibility of a material misstatement is minimized. In
that case, the analytical procedure constitutes substantive evidence in support of the fair
statement of the related account balances, and it is possible to perform fewer detailed tests in
connection with those accounts.
When to perform analytical Procedures? /Timing of analytical procedures
Analytical procedures may be performed at any of three times during an engagement. Some
analytical procedures are required to be performed in the planning phase to assist in
determining the nature, extent, and timing of work to be performed. Performance of
analytical procedures during planning helps the auditor identify significant matters requiring
special consideration later in the engagement.
Analytical are often done during the testing phase of the audit in conjunction with other audit
procedures. For example, the prepaid portion of each insurance policy might be compared
with the same policy for the previous year as a part of doing test of prepaid insurance.

Analytical procedures are also required to be done during the completion phase of the audit.
Such tests are useful at that point as final review for material misstatements or financial
problems are, and to help the auditor take a final "objective look" at the financial statement
that have been audited. It is common for a partner to do analytical procedures during the final
review of working papers and financial statements. Typically a partner has good
understanding of the client and its business because of ongoing relationships. Knowledge
about the client's business combined with effective analytical procedure is a way to identify
possible oversight in an audit.

6.5. Types of analytical Procedure

The usefulness of analytical procedures as audit evidences significantly on the auditors
developing an expectation of what a record account balance or ratio based account balance
should be, regardless of the type of analytical procedures used. Auditors develop an
expectation of an account balance or ratio by considering information from prior periods,
industry trends, client-prepared budget expectations, and non financial information. The
auditor typically compares the client's balance and ratios with the expected balances and
ratios using one or more of the following types of analytical procedures:
i. Compare client and industry data
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 ii. Compare client data with similar prior period data
iii. Compare client data with client determined expected results
iv. Compare client data with auditor-determined expected results
v. Compare client data with expected results, using non financial data
I. Compare client and industry data
Dear students, let us consider the following example to briefly see how comparison of client's
data with industry data will be made.

Client Industry
Items 2002 2001 2002 2001
Industry turnover 3.40 3.50 3.90 3.40
Gross margin (Percent) 26.30 26.40 27.30 26.20

If we look only at client information for the two ratios shown, the company appears to be
stable with no apparent indication of difficulties. However, if the auditor uses industry data to
develop expectations about the two ratios, for 2002, the auditor would expect both ratios for
the client to increase. Although these two ratios by them selves may not indicate significant
problems, the example illustrates how developing expectations using industry data may
provide useful information about the client's performance. For example, the company may
have lost market share, its pricing may not be competitive, and it may have incurred
abnormal costs, or may have obsolete items in inventory.

The most important benefits of using industry comparison are as an aid to understanding the
client's business and as an indication of the likelihood of financial failure.
A major weakness in using industry ratios for auditing is the difference between the
nature of the client's financial information and that of the firms making up the industry totals.
Because, the industry data are broad averages, the comparison may not be meaningful. Often
the client's line of business is not the same as the industry standards. In addition, different
comparisons follow different accounting methods and this affects the comparability of the
data.
II. Compare client data with similar prior period data
This is concerned with comparing the current data with the past data of the client. Suppose
that the gross margin percent for a company has been between 26 and 27 percent for each of
the past four years, but is 23 percent in the current year. This decline in the gross margin a
concern to the auditor if there is no expectation of a decline. The cause of the decline would
be a change in economic condition. However, it could also be caused by misstatements in the
financial statements such as sales or purchase cutoff errors, unrecorded sales, overstated
account payable, or inventory costing error. The auditor should determine the cause of the
decline in gross margin and consider the effect, if any, on evidence accumulation.
There are a wide variety of analytical procedures in which client data are compared with
similar data from one or more prior periods. These are:
 Comparing the current year's balance sheet with that of the preceding year.
 Comparing the detail of total balance sheet with similar detail for the preceding years.
 Compute ratios and percentages relation ships for comparison with previous years.
III. Compare client data with client determined expected results
Most Companies prepare budgets for various aspects of their operations and financial results.
Because budgets represent the client's expectation for the period, an investigation of the most
significant areas in which differences exist between the budgeted and the actual result may
indicate potential misstatements. In the audit of the local, state or federal governmental units
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 use this type of analytical procedure. When the client's data are compared with the budgets,
there are two special concerns.
i. The auditor must evaluate whether the budgets were realistic plans. In some organizations,
budgets are prepared with little care and therefore, are not realistic expectations. Such
information has little value as audit evidence. Hence, discussing budget procedures with the
client personnel is used to satisfy this concern.
ii.The possibility that current financial information was changed by client personnel to confirm
to the budget. If that is occurred, the auditor will find no difference in comparing actual data
with budgeted data even if there are misstatements in the financial statement. Therefore,
assessment of control risk and detailed audit tests of actual data are usually done to minimize
the likelihood of this concern.

IV. Compare client data with auditor-determined expected results

The second common type of comparison of client data with expected results occurs when the
auditor calculates the expected balance for comparison with the actual balance. In this type of
analytical procedure, the auditor makes an estimate of what an account balance should be by
relating it to some other balance sheet or income statement account or accounts by making a
projection based on historical data. An example of calculating an expected value based on
relationships of accounts is the dependence calculation of interest expenses on long-term
notes payable by multiplying the ending monthly balance in notes payable by the monthly
interest rates. An example of using historical trend would be when the moving average of the
allowance for uncollectible accounts receivable as a percentage of gross accounts receivable
is applied to the balance of gross accounts receivable at the end of the audit year to determine
an expected values for the current allowance.
V. Compare client data with expected results, using non financial data
Here, the non financial data are used by the auditor to verify whether the financial statement
is fairly stated.
Example, in audit of a hotel, auditor can determine the number of rooms, room rate for each
room, and occupancy rate. Using those data, it is relatively easy to estimate total revenue
from rooms to compare with the recorded revenue. The same approach can sometimes be
used to estimate such accounts as tuition revenue at university (average tuition times
enrollment), factory payroll (total hours worked times wage rate), and cost of materials sold
(units sold times material cost per unit).

6.6. Summary of Audit Procedures and Types of Evidence

Term and Definition Illustrative Audit Procedure Types of
Evidence
Examine a sample of vendors to
Examine- A reasonable detailed determine whether the goods and
study of a document for record services are reasonable and of the Documentation
to determine specific fact about type normally used by the client's
it business
Scan- a less detailed examination Scan the sales journal, looking for
of documents or record to large an unusual transaction Analytical
determine whether there is procedure
something unusual warning
further investigation
Read the minutes of board of
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Read- an examination of written director's meeting and summarizes
information to determine facts all information that is pertinent to Documentation
pertinent to audit. financial statement in a working
paper.
Calculate the inventory turnover
Compute- a calculation done by Rations and compare with those of Analytical
the auditor independent to the the previous years as a test of procedure
client. inventory obsolescence.
Re-compute the unit sales price
Re-compute- calculation done by times the number of units for a Re-performance
the auditor independent of the sample of duplicate sales invoices
client and compare the totals with the
calculations
Foot- Addition of numbers to Foot the sales journals for a one
determine whether the totals is month period and compare all Re-performance
the same as the client's totals with the general ledger.
Trace- An instruction normally Trace a sample of sale transaction
associated with documentation from the sales journal to sales Documentation
or performance. The instruction invoices and compare customer
should state what the auditor is names, date, and the total birr
tracing and when it is traced value of sales.
from and to. Often an audit
procedure that includes the term Trace postings from the sales Re-performance
trace will also include a second journals ledger accounts.
instruction such as compare or
recalculation
Compare- comparison of Select a sample of sales invoices
information in two different and compare the unit selling prices
locations. The instruction should as stated on the invoice to the list Documentation
state which information is being of units of selling prices
compared in as much detail as authorized by management.
practical.
Count- The act of observation Count petty cash on hand as the
should be associated with the balance sheet date. Physical
type of evidence defined as examination
physical examination.
Observe- The act of observation Observe whether two inventory
should be associated with the count team independently count Observation
type of evidence defined as and record inventory costs.
observation.
Inquire- The act of inquiry Inquire of management whether
should be associated with the there is any obsolete inventory on Inquiry of client
type of evidence defined as hand at the balance sheet date.
inquiry.
Vouch- The use of documents to Vouch a sample of recorded
verify recorded transactions or acquisition transactions to vendors' Documentation
amounts. invoice and receiving reports.

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