LECTURE ONE: GENERAL AUDITING ENVIRONMENT

Introduction
This lecture is aimed at providing the learner with basic knowledge of auditing

1.2 Specific objectives:

At the end of the lecture you should be able:

Define and explain the importance of auditing.
Describe the basic process of auditing
Conduct a simple audit.

Lecture Outline

Title 1.3.1: Definition of auditing

Title 1.3.2: True and fair view
Title 1.3.3: Objectives of an audit
Title 1.3.4: Distinction between auditing and accounting
Title 1.3.5: Types of audits
Title 1.3.6: Users of audited reports

Lecture
Definition of Auditing
The word ‘audit’ means independent investigation into the quality of published accounting
information. International Standards on Auditing (ISA) describes audit as an independent
examination and expression of an opinion on the financial statements of an institution by an
appointed auditor in pursuance of that appointment and in compliance with any relevant statutory
obligation. The purpose of an audit is not to provide additional information but rather it is
intended to provide the users of the accounts with assurance that the information
provided/presented to them is reliable.

True and Fair view

The companies Act requires that all limited liability companies’ appoint an auditor whose task is
to express an independent opinion as to whether the financial statements prepared by the
directors show a true and fair view of the financial performance and position of a company.
What constitutes true and fair is not defined by the Act. Previously the auditor was required to
certify as to the truth and correctness of accounts, the phrase true and correct implying arithmetic
accuracy. Such an approach ignored the overall view of the accounts, which are prepared using
subjective accounting policies and would be difficult to prove. It is not possible to certify that
one set of accounts is the correct set, because many accounting areas are subject to a wide variety
of interpretations and therefore presentation. As a result the auditor is only required to express an
opinion as to whether the accounts show a true and fair view of the state of affairs of the
company and of its profit or loss for the period.

Objectives of an audit

The primary objective of an audit of financial statements 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. (Financial reporting framework refers to the
international accounting standards, provisions of the companies Act and other relevant statutes
and legislation). The auditor expresses an opinion as to whether the financial statements give a
true and fair view of the financial position and performance of the company.

Other objectives
To give credibility to the financial statements. This arises from the fact that the accounts have
been subject to an examination by an independent person.
An audit may assist in the prevention and detection of errors and frauds.
The auditor’s experience will enable him to make recommendations on ways of improving the
accounting and internal control system.

Difference between Auditing and Accounting

Auditing Accounting

Involves examination of financial statements to Involves preparation of books of accounts to

prove the true and fair view of company’s affairs aid in decision-making.

It is done mainly at year-end after the directors

have prepared the financial statements, although It is a continuous process carried out
the planning work could be carried out earlier. throughout the financial period.
In preparing financial statements and
maintaining books of accounts, the
An audit is mainly governed by the international accountant is guided by generally accepted
standards on auditing (ISA). accounting standards
Accountancy is a management function
The auditor must be independent of all the aimed at assisting management to run the
stakeholders such as management. business in an orderly efficient manner
It is a statutory requirement that all
It is a statutory requirement that financial companies must maintain proper accounting
statements are audited. records.
Types of Audit
Audits can be classified in two broad ways according to: -

Terms of engagements i.e. nature of work done

Method of approach of work done.

1 Terms of engagement-nature of work done.

Statutory audits
These are carried out as per the requirements of the various statutes e.g. the Companies Act cap
486 requires that all public limited companies must have their financial statements subjected to
an independent audit. The objectives of the audit are to express an opinion as to whether the
balance sheet and the profit and loss account show a true and fair view. The rights and duties of
the auditor are laid out in the Companies Act or the relevant statute. The powers of appointment
of the auditor are vested on the shareholders.

Private audits
These are audits that are not governed by the Act. These are performed by an independent
auditor because the owners, members or other interested parties require them and not because the
law requires them to be carried out. Private audits are carried out for organisations such as
NGOs, partnerships, clubs and charities among others. The appointment of the auditor is usually
carried out as a private contract between the auditor and the relevant stakeholder. The scope and
objective of the work is determined by the agreed terms between the auditor and the client. The
auditors’ rights and duties are also laid out in the contract.

Comparison between private and statutory audits

Similarities
1) Both are carried out by qualified auditors.
2) They involve the assessment of the internal control system.
3) They facilitate detection of errors and frauds.
4) Reports issued by the auditors can be used by third parties.

Differences
Statutory Audits
1. It is a requirement of an Act of parliament e.g. the Companies Act.
2. The scope and objective of work is defined in the Act
3. The report is addressed to the shareholders.
4. Appointment of the auditor is stipulated in the Act (Sec.159). It can either be by
shareholders, directors or registrar of companies.
5. The auditor is liable to third parties.
6. The auditor has full independence.

Private Audits
1. It is not a requirement by the Act.
2. The scope is agreed between a client and the auditor therefore it is limited.
3. Report is addressed to relevant stakeholder.
4. Private appointment by the owner.
5. The auditor is not liable to third parties.

b) Method of approach to work.

Continuos audits
This is an approach whereby the audit is carried out throughout the financial period. The audit
work is carried out at predetermined intervals usually around three audit visits. This approach is
ideal for large organisations with tight reporting deadlines e.g. multinational banks.

Assuming that the work is carried out in three-audit visits spread over duration of four months,
the first audit visit will mainly entail carrying out detailed planning of the audit. Work carried
out will include;
Obtaining a good understanding of the clients business or updating the business understanding
obtained in the previous audits.
Identifying any developments in the clients business that could have a significant impact on the
audit such as new legislation.
Identifying any changes that have taken place at the client’s that could have an impact on the
audit such as changes in management.
Determining the number of staff members to be involved in the audit and the level of experience
required and whether there will be need to involve experts.

The second audit visit will be carried out usually half way through the financial period work
carried out will include;

Ascertaining, recording and testing the clients internal control systems.

Concluding on the level of reliance to be placed on the internal control system.
Carrying out limited analytical review on the interim financial performance of the company. This
will include carrying out ratio analysis.
Deciding on the level of substantive testing and the nature of substantive procedures to be carried
out.

The final audit visit will mainly entail review of the financial statements at the end of the
financial year. Work carried out will include;

Carrying out substantive procedures on the various account balances

Concluding whether there are any significant misstatements in the financial statements.
Final analytical review to verify whether the information obtained is consistent and whether the
view presented by the financial statements is consistent with the auditors understanding of the
business.
Forming an opinion as to whether the financial statements show a true and fair view.
Merits
1 Accounts are usually kept up to date.
2 Errors and frauds are discovered at an early stage.
3 The auditor gathers sufficient knowledge of the business as a result of his frequent visits.
4 Saves time during final audits.
5 Better report is developed, as time spent is more.

Demerits
1. It is expensive to have a continuos audit due to the amount of time spent.
2. Frequent disruptions of the clients work during the audit.
3. The auditor’s independence may be adversely affected by the continuous presence at the
clients premises.
4. Tendencies to over depend on auditing staff to solve accounting problems.
5. Interference of work, which has already been audited by the client’s staff.

Interim audits
This is an audit that is usually carried out mid way through the accounting period. an interim
audit usually precedes a final audit and is ideal for large to medium size companies.

Work carried out during an interim audit usually include;

Obtaining an understanding of the nature of the client’s business;
Evaluating any significant changes in the clients operating environment that could have a
significant impact on the client’s financial statements such as change in the management.
Ascertaining, recording and testing the clients accounting and internal control system.
Concluding on the level of reliance to be placed on the internal control system.
Plan and design the substantive procedures to be carried out during the final audit;
Reporting to management on any significant weaknesses identified in the internal control system.

Merits
1. It is ideal for dynamic businesses.
2. Compared to continuous audits it is cheaper.
3. It facilitates final audits.
4. Up to date accounts are kept.
5. Errors and frauds are prevented and detected at an early stage compared to final audits.
Demerits
1. Errors are at an advanced stage compared to continuos audits.
2. Over dependence on audit staff to solve accounting problem.

Final audits
Usually done at the end of the year on the financial statements i.e. the balance sheet and the
profit and loss account. A final audit can be conducted in two ways;

As a continuation of the interim audit for large to medium size organisations;

For small organisations the audit could be carried out in one single session after the end of the
financial period.

After examining the end year financial statements the auditor then forms his opinion as to
whether the financial statements show a true and fair view and reports this to the shareholders.
Other types of audits
Procedural audits
Requires an examination of procedures or records for reliability and accuracy. At the end the
auditor can add new ones, modify existing ones or scrap old ones. Attention is paid mainly to:

a. Company internal control system.

b. Laid down guidelines and procedures.
c. As changes made without auditors’ knowledge.
d. Records of the company.

Merits
1. Reveals any inefficient procedures.
2. Identifies strengths and weaknesses in the internal control system.
3. Creates harmony and co-ordination of company decision making process.
4. Identifies any bureaucracies

Demerits
1. It is expensive.
2. Management can frustrate the whole process if they do not want to reveal inefficiencies.
3. It could lead to duplication of effort.
4. It is tedious especially when many procedures are involved.
5. Sometimes the auditor may not understand technical procedures.
6. Procedures change to respond to changes in the economy on the social setting.
7. Where the internal control system is weak, it is of limited applicability.

Management audits
This involves investigation of the company’s entire management to ascertain whether the
management is running the organisation in the best interest of the stakeholders. It investigates
company’s managerial aspects of the business from high to low management. It assesses the
efficiency of management to run the organisation in the most viable way.
Merits
1. It improves management quality.
2. Help assists in solving any bureaucracies.
3. Reveals weaknesses of management’s.
4. The strengths and weaknesses of the internal control system are also seen.
5. It acts as a check to the efficiency of budgetary system.
6. Corrective measures may be initiated immediately.

Demerits
1. It lowers the morale of top management.
2. Management is unlikely to reveal its weaknesses when the auditor is present.
3. It is difficult to identify the department that is inefficient as all of them rely on each other
heavily.
5. It could lead to frustration of management as it can easily be biased.
6. It is difficult to monitor human actions and responses.
Balance sheet audits
Tests the strength of the internal control system by working backwards to get the initial
transactions. It is based on verification of assets by checking;

Description: Mainly of recording entries.

Ownership: Prove of ownership either by use of logbooks for cars or title deeds for land.
Value: Cost and method of depreciation.
Existence: Is the asset really there?
Merits
1. It is cheap compared to other audits.
2. A balanced opinion can be reached.
Demerits
1. It is a partial audit.
2. Applied only to business with strong internal control system.

Users of audited financial statements

The annual accounts and report are primarily prepared by the directors to the shareholders.
However, the following parties need financial statements.

i. Those parties with vested interests in a business.

Employees.
Creditors or suppliers
Lenders and debenture holders
The management
The shareholders to whom the financial statements are addressed.
Credit rating agencies.

ii. Those with potential interests

Potential shareholders
Trustees
Suppliers
Customers
iii. Those with representative interests
Lawyers
The government
The general public.

iv. Others
Competitors
Stock brokers
Statisticians
Financial journalists
Trade unions.
ASSIGNMENT ONE TO BE SUBMITTED
Activity 1:
Discuss the concept: value for money audit

Activity 2
Discuss why value for money audit is necessary

1.6 Self – Test Questions

Question One:
a) Identify the potential users of audited financial statements.
b) What are the specific needs of the potential users of audited financial
statements you have identified in (a) above?

Question Two
(a) (i) Briefly explain the meaning of the term “audit”
(ii) What are the objectives of an audit according to the Companies Act?
(b) List four advantages to a company of having its accounts audited
(c) Identify and list the responsibilities of company directors in relation to the
company’s accounting system.
1.6 Summary
(d) List five limitations of an audit
In this lecture you have learnt that:
1. The word ‘audit’ means independent investigation into the quality of
published accounting information
2. Company Act requires that a limited liability company should appoint an
independent auditor to express an opinion on whether the financial
statements prepared reflect a true and fair view of the company
3. Audit are divided in two broad ways including; Terms of engagements
i.e. nature of work done and Method of approach of work done.

1.7 Suggestion for further reading

Students are recommended to do further reading on the following;
1. The need for an audit in an institution