Chapter 1: An Overview of Auditing

Dear Learners!
Independent audit function plays an important role in business, economy and society.
Different decisions are typically based upon the information available to the decision maker.
To obtain the most benefit, users should have economic information that is both relevant
and reliable. This need for relevant and reliable financial information creates a demand for
accounting and auditing service. Auditing is 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 and
independent person. Auditing enable the auditor to express opinion whether the financial
statements are prepared, in all material respects, in accordance with an identified financial
reporting framework. This framework (criterion) might be generally accepted accounting
principles (GAAP), or the national standard of a particular country. In this chapter, you will
learn about meaning of auditing, historical development of auditing, types of audit and
auditors and economics of auditing.

Objectives of the Chapter: after completing study on this chapter, student be able to;
After studying this chapter, you should be able to:
1. Define auditing.
2. Describe Historical Development of Auditing.
3. Identify Types of Audits and Auditors.
4. Explain Economics of auditing

1.1. Nature and Definition of Auditing

Different scholars have defined auditing in different ways. For example, Auditing is a
process of collection and evaluation of evidence for the purpose of reporting on economic
transaction. The other definition of auditing given by the Institute of Chartered Accountants
of India, in its publication titled, General Guidelines on Internal Auditing has defined
auditing as ‗‘ a systematic and independent evaluation of data, statements, records,
operations and performances ( financial or otherwise) of an enterprise for stated purpose. In

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any auditing situation, the auditor perceives and recognizes the propositions before him for
examination, collects evidence, evaluates the same and on this basis formulates his/her
judgment which is communicated through audit report.

As it is cited in Kanal Gupta and Arora A.(1996,p6), Arens and Loebbecke defined auditing
as the process by which a complete, independent person accumulates and evaluates
evidence about quantifiable information related to specific economic entity for the purpose
of determining and reporting on the degree of correspondence between the quantifiable
information and established criteria. To sum up, Auditing is the process of verifying the
assertions produced by accounting, as to whether they present a true and fair view of the
entity's financial position in accordance with accounting standards and GAAP. In other
words, auditing seeks to verify whether or not financial records have been properly
prepared.

Study Note
 The term audit is derived from the Latin term ‘audire,’ which means to hear. In early days
an auditor used to listen to the accounts read over by an accountant in order to check
them Auditing is as old as accounting.
 It was in use in all ancient countries such as Mesopotamia, Greece, Egypt. Rome, U.K.
and India. The Vedas contain reference to accounts and auditing.
 The original objective of auditing was to detect and prevent errors and frauds and most
recently objective of audit shifted to ascertain whether the accounts were true and fair
rather than detection of errors and frauds.
 Auditing evolved and grew rapidly after the industrial revolution in the 18th century with
the growth of the joint stock companies the ownership and management became separate.
 The shareholders who were the owners needed a report from an independent expert on the
accounts of the company managed by the board of directors who were the employees.

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Activity
Question 1.1: Describe the meaning of auditing and discuss its evolution?
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1.2. Historical Development of Auditing

The development of auditing is closely linked to the development of accounting. In the early
stage of civilization, the number of transactions was usually so small that able to record the
transactions himself. However, with the growth of civilization and consequential growth in
volume and complexity of transactions, it becomes necessary to entrust the job of recording
the transactions to other persons. The trend started with maintenance of accounts to empires
by public officials. Almost simultaneously, a need was felt of institute to check on the
fidelity of persons responsible for maintaining the accounts. To accomplish this purpose, it
became customary 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
‘audiure‘‘ which means to hear.
The major development of auditing may be summarized as follows:
1. Auditing was conducted through a public hearing and its objective was verification of
cash receipts. It was simply a cash audit.
2. Auditing started to be conducted through examination of all the transactions of an
organization instead of hearing what the bookkeepers say the objective of auditing was
to detect errors and frauds.
3. The objective has become, starting from the first half of the 20 th century, determination
of whether the financial statements present the true and fair view of the organization.
4. Sampling technique has been introduced instead of examining each and every
transaction.
5. Computer is being used for effective carry out the auditing process.

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Study Note
 Starting from the first half of 20 century, the objective of auditing shifted to determine
whether financial statements present the true and fair view of an organization. Sampling
technique and the use of computer have been used in the auditing process in recent

times.
Activity
Question 1.2: Describe historical development of auditing.
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1.3. Accounting vs. Auditing

The company structure is built upon the principles of stewardship. Shareholders invest
capital into the company and hire professional managers to manage the company. The
disadvantage is that these same managers might perform fraud and errors. In public listed
companies, it is very hard for shareholders to actually check on the performance of
management. That is why accounting standards were developed. The standards prescribe the
proper procedures for financial reporting. But how do shareholders know whether or not
managers have been following these accounting standards? The answer is simple - the
auditor's report will tell them the answer. In other words, accounting standards are the law,
and auditors are the law enforcers.

Many financial statement users and members of the general public confuse auditing with
accounting. The confusion results because most auditing is concerned with accounting
information, and many auditors have considerable expertise in accounting matters. The
confusion is increased by the fact that auditing is performed by individuals described as
public accountants. Accounting is the process of recording, classifying and summarizing
economic events in a logical manner for the purpose of providing financial information for
decision making. Accounting involves tracking, reporting, and analyzing financial
transactions. It covers everything from preparing individual tax returns to preparing

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financial statements for multinational corporations, and is considered a fundamental
discipline within the field of accounting. An audit is an independent examination of
accounting and financial records and financial statements to determine if they conform to
the law and to Generally Accepted Accounting Principles (GAAP). Accounting is
constructive, it starts with the raw financial data to process and produce financial summary
through reports known as financial statements as the end product of its work. The function
of accounting, to an entity and to society as a whole, is to provide certain quantitative
information that management and others can use to make decisions. To provide relevant
information, accountants need to have a thorough understanding of the rules and principles
and provide the basis for preparing the accounting information.

Auditing on the other hand is analytical work that starts with the end product of accounting
to lend credibility and fairness of the measurements. In auditing, the concern is with
determining whether recorded information properly reflects the economic events that
occurred during the accounting period. Since the accounting rules and principles are the
criteria for evaluating whether the accounting information is properly recorded, any auditor
involved with this data must also thoroughly understand the accounting rules and principles.
In the context of the audit of financial statements these are generally accepted accounting
principles (GAAP).

In addition to understanding accounting, the auditor must also possess expertise knowledge
in the accumulation and interpretation of audit evidence, determining the proper audit
procedures, sample size, particular items to examine, timing of the tests, and evaluating the
results are unique to the auditor. It is this expertise that distinguishes auditors from
accountants.

Significance of Auditing to the society: There are a number of advantages of auditing to

the modern society. These are;
A tool of control over those who handle resources belonging to others
The first and foremost advantage of auditing is that it acts as a tool of control over those
who handle the resources belonging to others. For example, in the case of government
departments, audit seeks to ensure that the officials use the public funds properly. Whenever
a person or authority is entrusted with the resources belonging to others, it becomes

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necessary to exercise suitable control over such person or authority to ensure that the
resources are used properly. The mere fact that there would be an audit of accounts acts as a
check on those using the funds and makes them cautious. Similarly, it acts as a moral check
on employees, since they fear that any errors or frauds would be discovered by the auditor.
Thus it acts as a means of protection against misuse of funds and reduces the possibility of
errors and frauds.
A tool for enhancing credibility of economic information
This is another important advantage of auditing that it enhances the credibility of economic
information. It is obvious that one would place greater reliance on statement if it had been
audited than would be the case otherwise. This is because the auditor is an independent and
objective expert who has no stake in the management of the organization under audit. Thus,
the shareholders of a company would place greater reliance on the balance sheet and the
profit and loss account of the company, if the auditor expresses the opinion that this
statement presents a true and fair view. Apart from the shareholders, other users of financial
statements of an enterprise (like tax authority, banks, creditors, investors, labor-
representatives,) also place greater reliance on them if they have been audited.
A tool for improving economy and efficiency in the use of resources
Certain types of audit conducted specifically to review the operations and activities so that
wastages and losses can be minimized, weaknesses in the system can be identified and
overcome, and controls can be strengthened. In such audits (generally known as internal
audit or operational audit or management audit), the auditor makes recommendations for
improving the economy and efficiency with which resources are employed.
A tool for certain special audit
Some types of audit are conducted for certain special purposes such as for checking income
for tax purpose, emergent audit of a company cash in box, periodic checking of a company
inventories, etc. In summary, the contribution (need) of auditing from the view point of
owners, management, third parties like investors, creditors and employees, and the
government are discussed below.
To owners:
 Greater reliability of financial statements
 Improvement in efficiency with consequential audit increase in profitability

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 Over all check on integrity of management
To management:
 Improvement in management control and check integrity of employees
 Relatively easier to deal with third parties like banks, financial institution, creditors, and
insurance companies due to credibility of audited financial statements
 Greater reliability of tax returns
 Greater confidence of owners in management‘s integrity
 Assurance about compliance with specified legal requirements
 More efficient use of resources through identification of inefficiencies leading to the
remedial action
To potential investors, creditors, employees, and others:
Greater reliability of financial statements as providing a data base for taking investments,
credit, and other decisions.
To government:
 Greater reliability of financial and cost information as basis for policy decisions like
reduction/ increase in subsidies, tax rates, and for price fixation
 Greater reliability of tax returns submitted by taxpayers

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Study Note
The contribution of auditing from the view point of owners, management, third parties like investors,
creditors and employees, and the government are;
 Greater reliability of financial statements and over all check on integrity of management
 Improvement in efficiency with consequential audit increase in profitability
 Improvement in management control and check integrity of employees
 Relatively easier to deal with third parties like banks, financial institution, creditors, and
insurance companies due to credibility of audited financial statements
 Greater reliability of tax returns, Greater confidence of owners in management’s integrity and
assurance about compliance with specified legal requirements
 More efficient use of resources through identification of inefficiencies leading to the remedial
action.
 Greater reliability of financial statements as providing a data base for taking investments, credit,
and other decisions.
 Greater reliability of financial and cost information as basis for policy decisions like reduction/
increase in subsidies, tax rates, and for price fixation

Activity
Question 1.3: Discuss the advantage of Auditing for the economy.
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1.4. Types of Audits and Auditors

There are three types of audits. These are discussed below.
1. Financial Statement Audit: is conducted to determine whether or not financial
statements are presented in accordance with GAAP. The most common financial statements
that should be audited by the auditors are Balance sheet, Profit and loss statement, and cash
flow statement including the accompanying foot notes. Financial statement audits are
normally performed by firms of certified public accountants and users of auditor‘s report

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include management, investors, bankers, creditors, financial analysts, and government
agencies.
2. Operational Audit: is a review of any part of an organization‘s operation procedures and
method for the purpose of evaluating effectiveness and efficiency. This type of audit
examines:
 The economy of administrative activities in accordance with sound administrative
principles and practices, as well as management policies;
 The efficiency of utilization of human, financial, and other resources including
examination of information systems, performance measures and monitoring
arrangements, and procedures followed by audited entities for remedying identified
deficiencies; and
 The effectiveness of performance in relation to achievement of the objectives of the
audited entity and audit of the actual impact of activities compared with the intended
impact.
Here, some of the areas that should be audited are evaluation of organizational structure,
computer operations, production methods, marketing, and any other areas in which the
auditor is qualified.
3. Compliance Audit: the purpose of compliance audit is to determine whether the client is
following rules, procedures, regulations, and policies set down by the management. Such
type of audit includes the process prescribed by a company controller, reviewing wage,
bonus, and dividend rates, and examining contractual agreements. Like that of audits there
are also three types of auditors.
1. Independent (External) auditors: these are the auditors‘ of private audit firm. The
audit firm will sign audit contract in order to examine evidence and provide audit report
to the concerned party. Thus, the independent auditors received a fee from the audited
organization and they are primarily responsible to third parties (shareholders).
2. Internal auditors: are permanent employees of the client and get a monthly salary.
They are primarily responsible to the management or the board of directors. Internal
auditors lack independent in appearance (are not free from financial and family
relationship) from the client since they are the employees of the audited organization,
but they should satisfy independence in (Objective). To be objective:

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 They should not be a member of any committee in the organization
 They should provide their report not to the department heads rather to the manager.
3. Government auditors: are the employees of the government not the audited
organization.
They are the auditors‘ of Federal government and/or Regional government and primarily
responsible the legislative or executive body. Such type auditors will assign to audit
selective government organization.

Study Note
 The different types of audits are Financial Statement Audit, Operational Audit and
Compliance Audit
 The different types of audits are Independent (External) auditors, internal auditors and
Government auditors.

Activity
Question 1.4: Discuss about the different types of audits and auditors
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1.5. Economics of Auditing

Quality control policies and procedures should be implemented at both the level of the audit
firm and on individual audits. The audit firm should implement quality control policies and
procedures designed to ensure that audits are conducted in accordance with SASs, where
applicable. The nature, timing and extent of an audit firm's quality control policies and

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procedures depend on a number of factors such as the size and nature of its practice, its
geographic dispersion, its organization and appropriate cost or benefit considerations.
Accordingly, the policies and procedures adopted by individual audit firms vary, as does the
extent of their documentation.

The objectives of the quality control policies to be adopted by an audit firm ordinarily
incorporate matters set out below.
A. Requirements of professional ethics statements: personnel in the firm are to adhere to
the Statements of Professional Ethics especially relating to the principles of
Independence, integrity, objectivity, confidentiality and professional behavior.
B. Skills and competence: the firm is to be staffed by personnel who have attained and
maintain the technical standards and professional competence required to enable them to
fulfill their responsibilities with due care.
C. Acceptance and retention of clients: prospective and existing clients are evaluated and
reviewed on an ongoing basis. In making a decision to accept or retain a client, the
firm's independence and ability to serve the client properly, and the integrity of the
client's management are considered.
D. Assignment: audit work is assigned to personnel who have the degree of technical
training and proficiency required in the circumstances.
E. Delegation: sufficient direction, supervision and review of work at all levels are carried
out in order to provide reasonable assurance that the work performed meets appropriate
standards of quality.
F. Consultation: whenever necessary, consultation within or outside the firm is to occur
with those who have appropriate expertise.
G. Monitoring: the continued adequacy and operational effectiveness of quality control
policies and procedures are monitored.
The audit firm's general quality control policies and procedures should be communicated to
its personnel in a manner that provides reasonable assurance that the policies and
procedures are understood and implemented.

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Auditors should implement those quality control procedures which are, in the context of the
policies and procedures of the audit firm, appropriate to the individual audit. Auditors, and
assistants with supervisory responsibilities, consider the professional competence of
assistants to whom work is delegated when deciding the appropriate extent of direction,
supervision and review. Any work delegated to assistants is directed, supervised and
reviewed in a manner which provides reasonable assurance that such work is performed
competently and with due care. Assistants to whom work is delegated need appropriate
direction. Direction involves informing assistants of their responsibilities and the objectives
of the procedures they are to perform. It also involves informing them of matters, such as
the nature of the entity's business and possible accounting or auditing problems that may
affect the nature, timing and extent of audit procedures with which they are involved. There
are various means of directing assistants. For example, an audit program and oral briefings
during the course of the audit are important tools for the communication of audit directions.
Time budgets and the overall audit plan are also helpful in communicating audit directions.

Supervision is closely related to both direction and reviews and may involve elements of
both. Personnel carrying out supervisory responsibilities perform the following functions
during the audit:
A. monitor the progress of the audit to consider whether:
 Assistants have the necessary skills and competence to carry out their assigned
tasks; and
 They should understand the audit directions; and iii. the work is being carried out in
accordance with the overall audit plan and the audit program;
B. become informed of and address significant accounting and auditing questions
raised during the audit, by assessing their significance and modifying the overall
audit plan and the audit program as appropriate; and
C. Resolve any differences of professional judgment between personnel and consider
the level of consultation that is appropriate.

The work performed by each assistant is reviewed by personnel with greater competence
and experience to ensure that:

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  The work has been performed in accordance with the audit program;
 The work performed and the results obtained have been adequately documented;
 All significant audit matters have been resolved or are reflected in audit conclusions;
 The objectives of the audit procedures have been achieved; and
 The conclusions expressed are consistent with the results of the work performed and
support the audit opinion.
The following are reviewed on a timely basis:
 the overall audit plan and the audit program;
 assessments of inherent and control risks, including the results of tests of control and
the modifications, if any, made to the overall audit plan and the audit program as a
result thereof;
 documentation of the audit evidence obtained from substantive procedures and the
conclusions drawn there from, including the results of consultations; and
 Financial statements, proposed audit adjustments and the proposed auditors' report.
The process of reviewing an audit may include, particularly in the case of large
complex audits, requesting personnel not otherwise involved in the detailed audit to
perform certain review procedures before the issue of the auditors' report, e.g., to
consider specific areas of audit judgment and to review the draft annual report prior
to its publication and distribution. Finally, compliance with the auditing standards
contained in this SAS ensures compliance in all material respects with the basic
principles and essential procedures in International Standard on Auditing.
Activity
Question 1.5: Discuss about Economics of auditing and quality control procedures.
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Chapter Summary

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The original meaning of the term Audit is derived from the Latin word Audere‘ which
means ‘to hear‘ and the term Auditor is ‗one who hear‘. In earlier periods, commercial and
governmental records were approved only after a public reading in which the accounts were
read allowed to peoples those hear. From medieval period up to the industrial revolution
Audit were performed to determine whether person in position of official responsibility in
government and commerce were acting and reporting in an honest manner. During the
industrial revolution, manufacturing companies grew in size and their owners began to use
the service of hired managers. With this separation of the ownership and management
groups, the owners turned increasingly to the need of auditors to protect themselves from
the danger of intentional error as well as fraud committed by managers and employees.
Before 1900, consistent with this primary objective of detecting error and fraud, auditors
often include a study of all, or almost all recorded transactions. In the first half the 20th
century, the direction of audit works tends to move away from fraud detection towards a
new goal of determining whether financial statements give a full and fair picture of financial
position, operating results, and change in financial position. Although banks were the
primary users of financial reports, auditors become more responsible to stockholders,
government agencies and to other parties who might rely up on financial information. In the
middle of 20th century, the large scale corporate entities growth rapidly, and auditory began
to examine selected transaction rather than study all transactions. auditors and business
managers gradually comes to accept the careful examination of relatively few transactions
selected at random and they believe that it would be a cost effective and reliable indication
of the accuracy of other similar transaction. In addition to sampling, auditors become aware
of the importance of effective internal control. A company internal control consists of the
policies and procedures established to provide reasonable assurance that the objective of the
company will be achieved.

Auditor found that by studying the firm‘s internal control they could identify areas of
strength and weaknesses. Now a days, Auditors began to use sophisticated computer
software to test the intensity of firm‘s internal control and the accuracy financial statement
balances. Auditing is the systematic examination of records and documents to determine

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adequacy and effectiveness of budgeting, accounting, financial, and related policies and
procedures; compliance with applicable statutes, regulations, policies, and prescribed
procedures; reliability, accuracy, and completeness of financial and administrative records
and reports; and the extent to which funds and other resources are properly protected and
effectively used.

Glossary of Terms
Auditing is a systematic and scientific examination of the books of accounts of a business.
Audit is a verification of the results shown by the profit and loss account and the state of
affairs as shown by the balance sheet.
Auditor is a person or a firm appointed by a company to execute an audit.
Accounting is the process of recording, classifying and summarizing economic events in a
logical manner for the purpose of providing financial information for decision-making.
Audits of financial statements: - The goal is to determine whether the financial statements
have been prepared in conformity with generally accepted accounting principles.
Operational audits: - An operational audit is study of some specific unit of an organization
for the purpose of measuring its performance.
Compliance audits: - Compliance audit determines whether the specified rules, regulations,
or procedures are being carried out

Chapter Review Questions 1

Part I: Write ‘’TRUE’’ if the statement is correct and ‘’FALSE’’ otherwise.
1. The work of auditing begins after the work of accounting ends.
2. Internal auditors do not satisfy independent in appearance
3. One of the differences between accounting and auditing is that financial statements are
the input for the former and the output for the latter one.
4. In the early periods, auditing was conducted through a public hearing and its objective
was verification of true and fair view of an organization.
5. The development of auditing was not closely related to the development of
accounting.

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Part II: Choose the correct answer for the following multiple choice questions.
1. Review of any part of an organization‘s operation procedures and method for the
purpose of evaluating effectiveness and efficiency is;
A. Compliance audit
B. Operational audit
C. Internal Audit
D. Financial statement audit
E. None of the above
2. Independent auditing can best be described as; A. A branch of accounting.
B. A discipline that attests to the results of accounting and other functional operations
and data.
C. A professional activity that measures and communicates financial and business
data.
D. A regulatory function that prevents the issuance of improper financial information.
E. None of the above
3. Examining documents starting with the recorded transactions back to source documents
is;
A. Mechanical accuracy
B. Tracing
C. Vouching
D. Scanning
E. None of the above
4. A type of audit which may conduct to check whether each employee carryout his/her
duties and responsibilities based on the established policies, procedures, rules, and
regulations is called:
A. Financial statement audit
B. Operational audit
C. Compliance audit
D. Management audit
E. All of the above

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5. Individual auditors, whether government or public should be free from personal and
external impairment, this statement implies;
A. Due professional care
B. Competence
C. Independence
D. Proficiency
E. None of the above

Chapter 2: The Auditing Profession

Dear Learners!
Profession is a specialized body of knowledge that provides intellectual services to the best
interest of the public and which has gained public confidence and trust. Ethics consists of
moral principles and standards of conduct imposed by a profession on its members.
Professional ethics provides guidance to practitioners for maintaining professional attitude
and it encourages high level of performance.
The need for professional ethics arises out of characteristics of profession such as:
 Responsibility to serve the public

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  Complex body of knowledge
 Standard of admission to profession
 The need for public confidence
Professional Ethics in Public Accounting: Quotation by Marcus Aurelius‖ a man should
be upright; not be kept upright”. The thrust of this quote suggests that ideal conduct should
be expected not mandated by formal rules and regulations. But in reality, people are
motivated by a variety of conflicting pressures, for this reason, most professional
organizations promulgate a formal code of conduct. The purpose of this chapter is to
explore the role of self-regulation and address some of the ethical issues faced by
accountants and auditors, and to enable students to obtain a critical understanding of the
practice and function of auditing in ensuring the accountability of organizations to
interested parties.

Objectives of the Chapter: After studying this chapter, you should be able to;
1. Discuss about generally accepted auditing standards
2. Identify Professional ethics.
3. Describe the legal responsibility and liability

2.1. Generally Accepted Auditing Standards

Standards are means of measuring the quality and performance of auditors. In order to
provide and maintain uniformly high quality audit work there is a need to have generally
accepted auditing standards. There are ten GAAS recognized by AICPA which are divided
in to three categories.
1. General standard (skill, objective, & due care)
These standards speak to the capability in the field of accounting and auditing as well as
technical knowledge of specific industry or organization under audit, character, and
conscientiousness of auditors. The auditors‘ capability can be acquired through education
and experience. The auditors‘ character relates with their objectivity in performing the audit
work. In addition to auditors‘ capability and character, auditors should be wise or careful in
the audit activities.
Under this standard, there are three GAAS as shown below.

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a. The audit is to be performed by person or persons having adequate technical training
and proficiency as an auditor (competence).
b. In all matters relating to the assignment, independence in mental attitude is to be
maintained by the auditor or auditors (independence).
c. Due professional care is to be exercised in the performance of the audit and the
preparation of the report (careful, conscious, or wise).
2. Field work standards(well planning ,understanding the ICS &gathering sufficient
data) The standards of field work are necessary of an audit plan which would be developed
after the auditor has sufficient understanding of the client. This standard also requires an
auditor to gather sufficient evidence using various auditing techniques to issue an opinion
concerning the financial statements. Thus, there are also three standards of GAAS under
field work standards (planning, understanding the client‘s internal control system, and
competence of the audit work).
a. The audit work should be adequately planned. The reasons for planning the audit work
are:
 To complete the audit work based on the stated time
 It helps to the auditor not to skip some works if he/she became busy
 To assign assistances, if any
b. A sufficient understanding of ICS of the client is to be obtained in order to plan the audit
and determine the nature, timing, and extent of testing to be performed.
c. Sufficient and competence evidential data is to be obtained through inspection,
observation, inquiry, examination, and/or conformation to afford reasonable bases for an
opinion regarding the financial statements under audit.
3. Reporting standards (GAAP, consistency, disclosure, and fair opinion)
a. The audit report shall state whether or not financial statements are prepared in
accordance with GAAP.
b. The report shall identify those circumstances in which such principles have not been
consistently observed in the current period in relation to the preceding period.
c. Informative disclosures in the financial statements are to be regarded as reasonably
adequate unless otherwise stated in the report.

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d. 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. When an overall opinion cannot be expressed the reasons therefore should be
stated. In all cases when an auditor‘s name associated with financial statements, the
report should contain a clear-cut identification of the charter of the auditor‘s work, if
any, and the degree of responsibility he/she is taking. In other words, the auditor should
provide fair opinion to the concerned party.
The standards of reporting requires that the auditor should, in his/her report state whether
the financial statements are prepared according to GAAP, and state if these principles have
been applied consistently. The auditor should also describe the presence of necessary
information in the financial statements that may have material effect on the reported data.
After completing the audit, the auditor should issue an audit opinion on the financial
statements, and justify whatever the opinion.
Study Note
There are ten GAAS recognized by AICPA which are divided in to three categories.
 General standard( skill, objective,& due care)
 Field work standards(well planning ,understanding the ICS &gathering sufficient data)
 Reporting standards(GAAP, consistency, disclosure, and fair opinion)

Activity
Question 2.1: Discuss about generally Accepted auditing standards.
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 2.2. Professional Ethics
The American Institute of Certified Accountant‘s code of ethics consists of two parts: the
principles and the rules. The principles are basic frames of references for the rules. The
rules govern the performances of professional services by members and are enforceable
applications of the principles.
A. Principles: There are six Principles of Professional Ethics
I. Responsibilities:
In carrying out their services as professional, members should exercise sensitive professional
and moral judgments in all their activities. Auditors play significant role in the society by
rendering different types of services that are essential to make various decisions, which
involves usage of scarce resources. Therefore, all members have responsibilities to those who
use their professional services. Besides, auditor has responsibility to corporate which each
other to:
• Improve their profession
• Maintain the public confidence ,and
• Carryout the profession‘s self-governance responsibilities

Application of this principle increases the quality of professional services rendered by

auditors and thereby boosts the status of the profession.
II. The public interest:
Members should accept the obligation to act in a way that will serve the public trust and
demonstrate commitment to professionalism. The public interest of an auditor is the
collective wellbeing of the community of people and institutions that use its services. These
include clients, creditors, governments, employers, investors, and the public at large, who
rely on the objectivity and integrity of auditors. This reliance imposes high reliance of
responsibility on the auditors. In discharging their responsibilities, members of the
profession may encounter conflicting pressures between information providers and users.
This conflict would be resolved when auditors carryout their responsibilities with integrity.

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 Auditors should show their commitment to honor the public trusts to those who rely on their
services: i.e. they expected to provide quality services within integrity, objectivity, and due
professional care.
III.Integrity:
To maintain and broaden public confidence members should perform all professional
services with the highest form of integrity.
In order to maintain the public trust and confidence members should act in an honest
manner. Integrity is measured by what is right and just in the circumstances. Integrity
means in this case, acting according to the code of professional conduct (ethical standards).
IV.Objectivity and independence:
A member should maintain objectivity and be free of conflicts of interest in discharging
professional responsibility. A member in public practice should be independent in fact and
appearance when providing auditing and other attestation services. This principle requires
auditors to avoid circumstances that involve conflicts of interest. Independence in fact refers
that the auditor should maintain an objective and impartial mental attitude throughout the
engagement. Independence in appearance refers to the relationship between the CPA and
the client must appear to be independent to third parties. The auditors‘ opinion will get
credibility if the users perceive that the auditor as objective and impartial.

V. Due Care:
A member should observe the profession technical and ethical standards, strive continually to
improve competence and quality of service; and discharge professional responsibility to the
best of the member‘s ability. Due professional care applies to the exercise of professional
judgment in the conduct of the work performed. Due professional care implies that the
professional approaches matter requiring professional judgment with proper diligence.

VI.Scope and nature of service:

A member in public practice should observe the principles of the code of professional conduct
in determining the scope and nature of services to be provided. The auditor should consider the
above principles in deciding to provide the specific services in specific situations. In addition,
members should:

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 • Practice only in firms that have adequate internal control procedures
• Determine whether the scope and nature of other services requested by an audit
client would create a conflict of interest in providing auditing.
• Assess whether the requested service is consistent with his role as a professional

B. Rules:
Rule is an accepted principle or instruction that states the way things are or should be done,
and tells you what you are allowed or are not allowed to do:

Rule 101 Independence

A member in public practice shall be independent in the performance of professional
services as required by council. A member should be independent in financial statement
audit, review, and examination of prospective financial statements for his/her is attesting
information to third party. But he/she does not have to be independent in rendering
accounting, tax, or management advisory services.

The AICPA has also adopted the following interpretation of the rule. Independence shall be
considered to be impaired if, for example, a member has any of the following transactions,
interests, or relationships.
A. During the period of professional engagement or at the time of expressing an opinion, a
member or a member‘s firm:
1. Has/or was committed to acquire any direct or indirect financial interest in the
enterprise.
2. Was a trustee of any trust or executor or administrator of any estate if such trust or
state has or was committed to acquire any direct or material indirect financial
interest in the enterprises?
3. Had any joint, closely held business investment with the enterprises or with any
officer, director, or principal stockholders thereof that of material in relation to the
member‘s net worth or to the net worth of the member‘s firm.
4. Had any loan to or from the enterprise or any officer, director, or principal
stockholder of the enterprise. This prescription does not apply to the following loans

23
 from a financial institution when made under normal lending procedures, and
requirements:-Loans obtained by a member or a member‘s firm that are not material
in relation to the net worth of such borrower Home mortgages and Other secured
loans
B. During the period covered by the financial statements, during the period of the
professional engagement, or at the time of expressing an opinion, member or a
member‘s firm:
1. Was connected with the enterprise as a promoter, underwriter or voting trustee,
as a director or officer, or in any capacity equivalent to that of member of
management or of any employee.
2. Was a trustee of any pension or profit sharing trustee of the enterprise?
The above examples are not intended to be all-inclusive. To have a clear understanding of
the rules, in what follows we will see the application of independence rule in relation to
professional services, individuals, and time period.

Professional services; independence rules applies to auditing and other attestation services
such as review of financial statements, examination of financial forecasts. The
independence rule applies to:
 All parents or shareholders of the audit firm
 All managerial employees assigned to an office that significantly participates in the
engagement
 All professional staff personally participating in the engagement
Therefore, it is not required that all employees of the firm be independent if the client, i.e.
independence of the employee is impaired does not necessarily mean that independence of
the firm is also impaired. If independence of an employee having no managerial
responsibility is impaired, independence of the audit firm will be maintained by assigning
the employee to other engagements. If independent of a managerial staff is affected, he/she
has to be transferred to an office of the firm that is not significantly participating in the audit
engagement.

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Period: an auditor is required to be independent of the client during the following time
period
 During the period of examination(auditing) process
 During the period covered by the financial statements
 At the time of expressing the auditor‘s opinion(the date of the report)
During these time period holding of financial interest, or a commitment to acquire a
financial interest, establishing business relationships may adversely affect the auditor
independence.
Financial interest: According to the interpretation of rule 101:
 A member or a member‘s firm client cannot have any direct financial interest in the
client. Direct financial interest indicates any involvement in the client. Direct
financial interest comprises independence. Hence firm‘s entire partners and all
other professional staff that would participate in that specific engagement should
not have any direct financial interest. Indirect financial interest exists when a
member or a member‘s firm owns stock in a mutual fund, and/or when a member‘s
non-dependent close relative has a financial interest in the client.
 A member should not have joint closely held business investment with a client
company. Or officers, directors, or a principal stockholder of such enterprise that is
material to either of the member‘s or the audit firm‘s net worth.
 A member is not permitted to have any loan to or from a client, or its officers,
directors or principal stockholders, which is not made under normal lending,
procedures, terms and requirements. This prevents any favoritism that affects or
(appear to have affected) the auditor‘s independence.

The following may considered as ways of maintaining independence:

• Training: members should be adequately trained to help them understand the
technical standards relevant to various types of professional engagement. Advice
should also be given to members for specific situations.

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 • There should be a controlling body that sanctions the public accounting firm and
or auditors for misconduct.
• Public accounting firms should give much emphasis to independence as it is the
vital means of gaining reputation, and therefore there should be internal pressure that
forces members to act in professional manner. Before accepting a new client public
accounting firms should evaluate as the existence of threats of independence.

Rule 102 integrity and objectivity

In the performance of any professional service a member shall maintain objectivity and
integrity. Integrity means being honesty or truthfulness whereas objectivity refers to
members to be free of conflicts of interest and shall not knowingly misrepresent facts or
subordinate his/her judgment to others.
This rule requires the members to be free of any bias and his/her opinion should be based
on facts rather than on any predetermined judgments, and it applies to all types of
professional services rendered by the CPAs.

Rule 201 General standards

A member in public practice shall comply with the following standards and with any
interpretations thereof by bodies designed by council.
A.Professional competence: undertake only those professional services that the member or
the member‘s firm can reasonably expect to be completed with professional competence.
B. Due professional care: members should exercise due professional care in the
performance professional services.
C.Planning and supervision: a member should adequately plan and supervise the
performance of professional services.
D.Sufficient and relevant data: a member should obtain sufficient and relevant data to
afford basis for conclusion or recommendations in relation to any professional service
performed. All types of professional services rendered by CPAs should be performed with
competence and due professional care. Before accepting any professional engagement,
CPAs should evaluate the capability to carry out the assignment according to the
professional standards. For example, if the client organization has a sophisticate electronic

26
data processing system, the firm should make sure the availability of a professional staff
having detailed computer knowledge. If such a person is not available, the engagement
should not be accepted since it cannot be performed completely.

Rule 202 Compliance with standards

A member who performs auditing reviewing, compilation management, consulting tax or
other professional services shall fulfill with the standards circulated by bodies designated by
council.
Rule 203 Accounting
Principles
A member shall not:
1. Express an opinion or state affirmatively(positively) that the financial statements or
other financial data of any entity are presented in conformity with GAAP, if such
statements or data contain any departure from accounting principles disseminated by
bodies designated by council to establish such principles that has a material effect on
the statements or data taken as a whole or
2. State that he/she is not aware of any material modifications that should be made to
such statements or data in order for them to be in conformity with GAAP, if
however the statements or data contain such a departure and the member can
demonstrate that due to unusual circumstances the financial statements or data
would otherwise have been misleading the member can comply with rule by
describing the departure, its approximate effect if possible, and the reasons why
compliance with the principle would result in misleading the statements.
An auditor should not issue unqualified opinion on financial statements unless these
statements are prepared according to the principles and standards outlined by the various
designated bodies like the Financial Standard Board (FASB). However, if application of the
principles and standards results in misleading financial statements, the auditor should
express the departure and show the effect of the departure in the financial statement.
Rule: 301: Confidential client information
A member in public practice shall not disclose any confidential client information without
the specific consent of the client. Auditors, due to their profession, do have access to

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confidential client information. Some of such information may be of sensitive nature and
may negatively affect the client, if disclosed. Hence, an auditor should not disclose any
confidential client information without a written consent of the client. But this rule also
requires the auditor to fulfill his/her legal and professional requirements when there is a
need to disclose relevant information to third party (legal bodies) without the authorization
of the client. In this case the auditor may become liable for disclosing confidential client
information, if it results loss to the client, he/she may also become liable for not disclosing
criminal acts of the client.

Rule: 501 Acts discreditable

A member shall not commit an act discreditable (shameful) to the profession. This rule
requires auditors to avoid acts that may damage the reputation (name or status) of the
profession. All acts that may create negative attitude towards to the profession cannot be
mentioned. However, the following are identified by the AICPA as acts that may adversely
affect the reputation of the profession.
I. Retention of client records and auditor working papers such as adjusting entries in to
complete the client records.
When auditors are discharged their services, they may retain working papers to enforce
payment of their fee. Since the working papers are property of the auditors such retention
may not considered as unethical. But if the working papers are the only supporting
documents for client‘s financial records, the auditors should give the working papers to the
client after payment is collected.
II. Discrimination in employment: Employment should not be based in age, sex, color,
race, or any other discriminatory acts.
III. Failure to follow standards and/or other procedures, or any other requirements in
governmental audit.
IV. Negligence in carrying out duties and responsibilities
A member should carry his/her duties with care. Acting negligently reduces the quality of
the professional services, which in turn would reduce the public trust and confidences.

Rule: 502 advertising and other forms of solicitation

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A member in public practice shall not seek to obtain clients by advertising or other forms of
solicitation in a manner that is false, misleading, or deceptive. Solicitation by the use of
coercion (force), over-reaching or harassing conduct is prohibited. The major points of rule
502 are:
 Members should not try to obtain work in unprofessional manner.
 Members should not make comparisons with other implying that services provided by
others is of inferior in quality
 Fees for professional work should be quoted with great care
 No fees, commission or reward should be given to third party for introduction.

Rule: 503 Commission and referral fees

Prohibited commissions: a member in public practice shall not for a commission
recommend or refer to a client any product or service, or for a commission recommends or
refers any product or service is to be supplied to a client, or receive a commission when the
member or the member‘s firm also performs for that client:
a. An audit or review of financial statement
b. A completion of a financial statement when the member expects. Or reasonably might
expect that a third party will use the financial of independence
c. An examination of prospective financial information
This prohibition applies during the period in which the member is engaged to perform any
of the services listed above and the period covered by any historical financial statements
involved in such listed services.
Disclosure of permitted commission: a member in public practice who is not prohibited by
this rule from performing services or receiving a commission and who is paid or expects to
be paid a commission shall disclose that fact to any person or entity to which the member
recommends or refers a product or service to which commission relates.
Referral fees: any member who accepts a referral fee for recommending or referring any
service of a CPA to any person or entity or who pays a referral fee to obtain a client shall
disclose such acceptance or payment to the client. In most cases clients consult their CPAs
for advice on products or services they plan to acquire. A member shall not recommend or
refer to client a product or service if the member is involved in audit reviews, or

29
compilation or examination of prospective financial information. If the member or the
members firm is not involved in the above mentioned activities, the member may receive
commissions and referral fees, and should disclose the existence of the commission to the
client.

Rule: 505 Form of organization and name

A member may practice public accounting in a form of organization permitted by a state law
or regulation whose characteristics conform to resolution of council. A member shall not
practice public accounting under a firm name that is misleading.
Rule 505 requires members of the public accounting practice not to form and operate a firm
under a misleading name, regardless of whether it is formed as a professional corporation,
partnership, or sole proprietorship.
In order to establish a public accounting firm as a professional corporation, the following
conditions should be met:
 All shareholders must be engaged in the practice of public accounting
 The principal executive officer shall be a shareholder and director
 To the extern possible all other director & officer should be CPAs an examination of
prospective financial information.
Study Note
 The American Institute of Certified Accountant’s code of ethics consists of two parts: the
principles and the rules. The principles are basic frames of references for the rules. The
rules govern the performances of professional services by members and are enforceable
applications of the principles. There Are Six Principles of Professional Ethics and rules
govern the performances of professional services by members.

Activity
Question 2.2: Discuss about the professional ethics and code of conduct for auditors.
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________

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__________________________________________________________________________
__________________________________________________________________________

2.3. Legal responsibility and Liability

An auditor has legal liability and responsibility to his/her client due to contractual obligation
and to third party under the common law. An auditor becomes legally liable for breach of
contract under contractual law for failure to detect embezzlement or fraud committed by
client employees. The client may sue the auditor alleging (claiming) that the auditor was
negligent in not detecting the scheme. The auditor will be liable if he/she is proved that the
reason for not detecting fraud is his/her negligence. But the auditor may not be liable if,
performed his/her duties according to GAAS and/or if the auditor proves that his/her
negligence was not the main cause of the client‘s loss. An auditor has an obligation to
exercise due professional care in rendering any type of professional service, even if this
obligation is not specifically stated in the contract. Failure to exercise due professional care
has two aspects: ordinary negligence and gross negligence.
Ordinary negligence: an auditor is considered to be negligent when he/she fails to act
professionally or when he/she fails to exercise the degree of care (unintentionally) a
reasonable person would exercise under the same circumstances which results damages to
another party.

Gross negligence: refers to failure to exercise due professional care intentionally to

deceive or uncover fraud. The auditor may use contributory negligence (negligence on
part of plain-tiff has contributed to the loss) as a defense if the client has contributed for the
incurrence of losses or for the damages caused to the client by the auditor‘s negligence. The
concept of comparative negligence is used by the court to allocate damages between
negligent parties based on the negligent parties.
Case on Comparative Negligence: Calvert Roth, CPA, for five years, has audited financial
statement of Metro Bank, at the end of each audit, he suggested improvements in bank’s
internal control over consumer loans, but the bank neglected. In the last year a fraud was
discovered that Harold Key, a loan officer had embezzled funds through creation of

31
fictitious consumer loans. Bank filed the case against auditor. The judge followed principle
of comparative negligence and allocate damages between bank (80) and auditor (20%).

Auditors may become liable to third party if the third party proves that it sustained loss as a
result of decisions made relying on the auditors‘ opinion, and that the auditors were guilty
(accountable) of certain degree of negligence. Auditors may be sued for misleading others
associating their name with professional services other than auditing. Therefore, the auditor
should clearly show his/her position in such service, e.g. marking‘‘ un audited‘‘ on the
financial statements compiled.

In general, an auditor may be sued for negligence for acts of others, lack of privileged
information for attempting to withhold information that is not privileged, or for not
discharging his/her legal responsibilities mentioned under rule 301. Auditors may also be
held liable for failure to apply GAAS or GAAP, for not reviewing events subsequent to
balance sheet date, and for not disclosing information that may have material effect on the
financial statements. Moreover, auditors have legal liability to their colleagues, to potential
investors, to creditors, financial institutions, to the government, and to any stakeholders of

the audited financial statements in giving honest information.

The degree of negligence required to establish the auditors‘ liability varies from one
jurisdiction to another. There are three general approaches;
Ultra mares: under this, CPAs are held responsible for ordinary negligence only to the third
party beneficiaries. Other third parties must prove gross negligence on part of the auditors.
Illustrative Case (Ultra mares and Touché Co. (1931): auditors issued unqualified opinion
(Clean opinion) on balance sheet of a company. On this basis, Ultra mares made loans to a
company. Later a company was declared bankrupt. Ultra mares sued auditors for ordinary
negligence.

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Restatements of Torts: under this liability for ordinary negligence to third parties is
extended to include any limited class of parties that could be foreseen to rely upon financial
statements.
Illustrative Case: Dianne Holiday, CPA, performed audit for Lyman Corporation. Lyman
intended to use audit report for bank loans, but no specific bank name mentioned. First
national bank and Dime Box State bank gave loans and also Wallace Manufacturing
Company provided trade credit. Lyman Corporation declared bankruptcy.
Decision: Banks form a limited class of third party. Wallace Company should prove gross
negligence.
Rosenblum: it extends the auditors liability for ordinary negligence even further to include
any third party, the auditor could reasonably foresee as receipts of the financial statements.
Illustrative Case: Rosenblum and Adler case (1983): auditors issued an unqualified report
on the financial statement of Giant Store Corporation. Rosenblum sold a showroom
business for shares of Giant stock to Giant Store Company. Giant became bankrupt.
Rosenblum sued auditors for ordinary negligence. The trial dismissed the case, but New
Jersey Supreme Court reversed lower court decision. It extended auditor’s liability to other
third parties which can be reasonably foreseen.
Study Note
 An auditor has legal liability and responsibility to his/her client due to contractual
obligation and to third party under the common law.
 An auditor becomes legally liable for breach of contract under contractual law for failure
to detect embezzlement or fraud committed by client employees.
 The client may sue the auditor alleging (claiming) that the auditor was negligent in not
detecting the scheme.
 The auditor will be liable if he/she is proved that the reason for not detecting fraud is
his/her negligence. But the auditor may not be liable if, performed his/her duties
according to GAAS and/or if the auditor proves that his/her negligence was not the main
cause of the client’s loss.

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Activity Question 2.3: Describe the legal liability and responsibilities of auditors and
indicate scenarios in which auditors may be liable.
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________

2.4. The auditing profession: Views on the Ethiopian Experience

In Ethiopia, auditors are liable to the client and third party for losses they cause in exercise
of their and punishable in accordance with the penal code.
Article 380 of the commercial code of Ethiopia (1960) states that:
1. Auditors shall be civilly liable to the company and third parties for any fault in the
exercise of their duties that occasioned loss.
2. An auditor who knowingly gives or confirms an untrue report concerning the
position of a company or fails to inform the public prosecutor of an office, which he
knows to have been committed, shall be punished under Article 438 or Article 664
of the penal code as the case.
The civil liabilities of the auditor arise if he/she has caused a loss to his/her clients through
his/her negligence or non-performance. These liabilities are governed under the contract
provisions of the commercial code.
Art. 2031 of the civil code, which addresses professional default, states the following;
(1) A person practicing a given profession or activity shall in the practice of such
profession or activity observe the rules governing that practice.
(2) He/she is liable where after due consideration of scientific data or rules recognized
by the practitioners of his/her profession, he/she appears to be guilty of imprudence
or negligence constituting definitive disregard of duty.

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Study Note
 In Ethiopia, auditors are liable to the client and third party for losses they cause in
exercise of their and punishable in accordance with the penal code.
 According to Article 380 of the commercial code of Ethiopia, auditors shall be civilly
liable to the company and third parties for any fault in the exercise of their duties that
occasioned loss and knowingly gives or confirms an untrue report concerning the
position of a company or fails to inform the public prosecutor of an office, which he
knows to have been committed, shall be punished under Article 438 or Article 664 of the
penal code as the case.

Activity
Question 2.1: Discuss situation under which auditors are liable in Ethiopia.
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________

Chapter Summary
This chapter covered the basic codes of professional conduct, which the auditors need to
bear in mind in carrying out their duties. The main source of material for code of
professional conduct in this unit is the AICPA‘s code of professional ethics. Standards are
established to measure the quality and performance of individuals and organizations.
Standards relating to the auditing profession concern themselves both with the CPA‘s
professional qualities and with the judgment exercised by CPA‘s in the performance of their
professional engagement. Our purpose in this topic is to make clear the nature of generally
accepted auditing standards (GAAS). In our discussion of GAAS, we consider mainly on
the nature of the independent auditor‘s report. The existence of GAAS is evidence that
auditors are very concerned with the maintenance of a uniformly high quality of audit work
by all independent public accountants. GAAS consists of

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General Standards
1. The audit is to be performed by a person or persons having adequate technical
training and proficiency as an auditor.
2. In all matters relating to the assignment independence in mental attitude is to be
maintained by the auditor or auditors.
3. Due professional care is to be exercised in the performance of the audit and the
preparation of the report.
Standard of field Work
1. The work is to be adequately planned and assistants, if any, are to be properly
supervised.
2. A sufficient understanding of the internal control structure is to be obtained to plan
the audit and to determine the nature, timing, and extent of test to be performed.
3. A sufficient competent evidential matter is to be obtained through inspection,
observation, inquiries, and confirmation to afford reasonable bias for an opinion
regarding the financial statements under audit. Standard of Reporting
1. The report shall state whether the financial statements are presented in accordance
with GAAP.
2. The report shall identify those circumstances in which such principle have not been
consistently observed in the current period in relation to the preceding periods.
3. Informative disclosures in the financial statements are to be regarded as reasonably
adequate unless otherwise stated in the report.
4. The report shall either contain an expression of opinion regarding the financial
statements, taken as a whole, or an assertion to the effect that an opinion cannot be
expended.

Glossary of Terms
Profession is a specialized body of knowledge that provides intellectual services to the best
interest of the public and which has gained public confidence and trust.
Ethics consists of moral principles and standards of conduct imposed by a profession on its
members.

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 Chapter Review Questions 2
Part I: Write ‘’TRUE’’ if the statement is correct and ‘’FALSE’’ otherwise.
1. Auditors have legal liability and responsibility to the stakeholders in particular and to
the public in general.
2. The difference between gross and ordinary auditors‘ negligence is that the latter may
happen due to their deliberate act.
3. The need to maintain independence in mental attitude in all matters pertaining to the
audit is standards of field work.
4. A CPA firm is reasonably assured of meeting its responsibility to provide services that
conform to professional standards by adhering to generally accepted auditing
standards.
5. An auditor should maintain an objective and impartiality in his/her audit engagement;
this implies objectivity.

Part II: Choose the correct answer for the following multiple choice questions.
1. All of the following are the dilemmas faced by professionals to give priority for public
interest than personal , except
A. Financial relationship
B. Family relationship
C. Friendly relationship
D. All of the above
E. None of the above
2. -----------------refers to the awareness or consciousness of auditors at the time of
discharging their duties and responsibilities.
A. Integrity
B. Scope of the audit
C. Due care
D. Public interest
E. None of the above
3. Of the following one is unique from others, identify
A. Planning the audit

37
 B. Understanding the client‘s internal control system
C. Obtaining sufficient & reliable audit evidence
D. Due professional care
E. None of the above
4. A principle that states ―A member should observe the profession technical and ethical
standards, strive continually to improve competence and quality of service‖ is;
A. Due care
B. Public interest
C. Responsiveness
D. Independence
E. Integrity
5. The need for professional ethics arises out of the following, except:
A. Responsibility to serve the public
B. Complex body of knowledge
C. Standard of admission to profession
D. The need for public confidence
E. None of the above

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 Chapter 3: Planning and Conducting the Audit
Dear Learners!
As we have discussed in the earlier chapters, the audit work should be performed by person
or persons having adequate training and skill about the audit procedures. The audit
procedures have various stages or phases. Auditors are responsible to do different tasks
fairly and independently during these various phases of audit process. The three major
phases of the audit work are planning the audit work, performing the field work of auditing,
and reporting audit findings.

Objectives of the Chapter: After completing study on this chapter, you are expected
to;
1. Discuss reasons for Audit planning
2. Describe audit planning procedures
3. Understand Designing of Audit program
4. Prepare audit working paper
5. Discuss about audit risk
6. Discuss about materiality in auditing

3.1. Reasons for Audit Planning

Audit planning is the process of determining an overall strategy for the conduct and scope of
the engagement. There are many reasons for planning the audit work. Some of them are
discussed below.
 To enable the auditors to obtain sufficient and competent evidence for the
circumstance
 To keep reasonable audit cost. If the organization is complex, senior auditors are
required and high cost will be incur to perform the audit work. On the other hand if
the organization is small, junior auditors are required and less cost will be incur.
 To avoid misunderstanding with the client
 To complete the audit work based on the schedule
 To assign assistant, if any.

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3.2. Audit Planning Procedures
As per Auditing and Assurance Standard 1, ―Basic Principles Governing an Audit‖, Audit
Planning is one of the basic principles. Accordingly, it states the auditor should plan his
work to enable him to conduct an effective audit in an efficient and timely manner. Plans
should be based on knowledge of the client‘s business. Plans should be made to cover,
among other things acquiring knowledge of the client‘s accounting systems, policies and
internal control procedures; establishing the expected degree of reliance to be placed on
internal control; determining and programming the nature, timing, and extent of the audit
procedures to be performed; and coordinating the work to be performed. Plans should be
further developed and revised as necessary during the course of the audit . Audit planning
process includes:
A. Pre-plan
B. Obtained back ground information
C. Obtain information about client‘s legal documents
D. Develop overall audit programs
E. Schedule the audit work
F. Assigning professional staff to engagement.
1. Pre-plan: before planning the audit work, auditors should do two things:
i. Client acceptance (accept or reject the audit
contract) ii. Obtain an understanding with the client
Auditors should avoid clients who lack integrity. That is auditors should evaluate public
image, financial stability, relationship with the previous auditors of a new client. To do this,
the auditor should read the past financial statements of the client, contract with past and
present business associates like banks and attorneys, by discussing with the potential client
the need for the audit, and by contacting the potential client‘s former auditors with the
consent of the organization. If there are no serious doubts raised about the integrity of the
client, then the auditor will sign to close a deal. The audit contract is called an Engagement
Letter. The audit engagement letter includes the following expressed duties:
 The nature of the work to be performed
 The dead line of the audit contract
 The amount of the audit fee

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  Limitations of the auditor with respect to detection of errors, irregularities, and
illegal acts.
2. Obtaining background information
Auditors should have feedback about the client‘s unique accounting requirements, the
possibility of risk, and the controlling system on its assets. Different forms of enterprises
require different accounting requirements. For instance, if the client is Construction
Company, percentage of contract completion is applied or required to recognize revenue.
On the other hand if the client is government organization, government accounting is used.
Thus, the auditor should identify the client‘s accounting requirement and follow appropriate
audit procedures at times when he/she performs the audit work. The possibility of risk also
varied from client to client. That means the chance of occurring errors, irregularities, illegal
acts, and misuse of cash or other resources may vary from one organization to the other. In
order to adjust or aware themselves about their future activities, auditors should get
feedback about the problems of the client.

Finally, the auditor should tour (observe) the client‘s personnel and assets controlling
technique. For example, if the auditor sees the store keeper sleeps at his/her desk with the
store door open, or the casher talking on the phone while he/she is counting money, there
will be the sign to weakness in the client‘s internal control system. Or if the auditor sees
broken or obsolete equipment, that might be the signal that plant assets are possible
overvalued.
3. Obtaining information about the client’s legal documents
There are three documents of the client that should be observed by the auditors. Examining
these documents and records enable auditors to enter prate related evidences during their
engagement. The three legal documents are discussed below:
I. Corporate charters and by laws
II. Minutes of meetings
III. Contracts
I. Corporate charters and by laws: the corporate charter is granted by the government in
which the company is incorporated. It includes name, address, date of establishment, types
of business activities, voting right, dividend allocation systems, etc. By laws include rules

41
and regulations adopted by the organization in order to accomplish different activities of the
organization.
II. Minutes of meetings: are the official records to the meetings of the management and
higher body of the organization. These minutes of meeting include the management
decision such as compensation of officers, bonus rates, dividend rates, etc.
III. Contracts: clients may enter in to different contracts to others like pension plans,
contracts with suppliers, government contracts with completion and delivery of
manufacturing products, lease, etc.

In general, if the auditor have information about the three legal documents of the client
before starting his/her main task, he/she will be aware and inform about such information
while examining and evaluating the difference evidences of the client and finally he/she is
adequate to give suggestion and recommendation in his/her final report.
4. Develop overall audit report
An audit program is the detailed list of the audit procedures to be pertained by the auditor in
examining the financial statements. Before starting the work, the auditor should ordinarily
establish a preliminary program for a review this audit program should be documented in a
manner that will permit the auditor to record completion of the audit work and identify work
that remains to be done. As the work progresses, the auditor should evaluate the adequacy
of the program based on information gathered during the audit. The audit program may be
modified if the auditor believes that the planned procedures are not sufficient. The
objectives of preparing audit program are:
 To assist in planning the audits so that efficient and effective procedures are applied in
accordance with the audit strategy
 To provide clear instruction to staff as to the nature, extent, and timing of the audit
work.
 To provide a record of the work done and the conclusions drawn, as a basis for effective
quality control and to meet audit evidence requirements.
An audit program has two major sections.

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a. The system section: this section of the audit program focuses on the procedures used to
evaluate the effectiveness of the internal control structure and it is organized around
major transactions cycles of the internal control structure.
b. The substantive test section: this section deals with the procedures for substantive
testing of financial statement amounts and the adequacy of financial statement
disclosures. Besides this section of the audit program is organized in terms of major
financial statement items.
5. Scheduling the audit work
Auditors should plan or forecast the beginning and ending of the audit work. In order to
complete based on the established time in advance. One of the completeness of the auditors
is measured whether they complete their work based on the stated time in the contract.
6. Assigning professional staff to engagement
The final phase of planning of the audit work is assigning of professional staff to engage the
audit work. As we have been discussed earlier, the audit work should be done by those
having sufficient skill. Assistance should also assign, if necessary. Once the auditor is clear
about the objectives and internal control system of the client, he/she has to collect and
evaluate relevant evidence for his/her audit work through different techniques. These
various ways of evidence accumulation techniques are discussed below.
A. Physical inspection: the auditor may physically inspect the actual existence of certain
assets. For instance, the auditor may count cash box, observe the physical handling of
inventories though it is not necessary that handling of inventories means ownership
because goods may be handled on behalf of the others.
B. Examination of documents: the auditor may collect relevant data by examining related
documents. Thus, the auditor who wishes to verify the payment of cash for any reason
may examine or test checks stubs, for purchase of merchandise on account he/she may
verify purchase invoice, for receipts of cash from any source the auditor may check
receipt stubs, and so on. Examination of documents can be performed through:
i. Vouching: examining documents started with the recorded transactions (journals,
ledger, F/S) back to source documents, called test of occurrence.
ii. Tracing: determining whether source documents have been properly recorded in
the accounting record, called of completeness.

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iii. Scanning: verifying documents through quick or selective reading of the recorded
documents of the client.
iv. Mechanical accuracy: are checks of work performed by others such as verifying
client computations of the balance of accounts. For example, re calculating the
balance of A/P, A/R, cash, etc.
C. Questionnaires (Inquiry): the auditor also can collect relevant information through
preparing questionnaires. The auditor may obtain primary data (from those related
persons e.g. employees) or secondary data (from unrelated persons e.g. outsiders) about
certain information.
D. Confirmation letter: the auditor may obtain evidences through confirmation from the
third parties such as banks, debtors, and creditors about the balance of some accounts.
There are two confirmation letters- positive and negative.
i. Positive confirmation letter: is prepared when the client asks his/her or its business
associates such as banks, creditors, or debtors to give response to the auditor whether
or not the balance of the concerned account is similar. For instance, the client may
ask the creditor about the similarity or difference in the balance of Accounts
Receivable and a response to the auditor for the auditor‘s address.
ii. Negative confirmation letter: is prepared when the audited organization asks its
business associates to give a response to the auditor only if there is difference in the
balance of accounts.
E. Analytical review: the auditor can compute significant ratios, carryout a trend analysis
or compare and contrast different accounting data in order to gather necessary evidence
for his/her audit task. The comparison may be between current and past data, current and
anticipated (budgeted) data, company information and industry average, or current
information with current information.

3.3. Designing of Audit program

The success of audit plan depends on sound and solid audit Program. An audit plan is the
Auditor‘s plan of action. The audit Program is specially designed for each audit is a plan of
the work of examination and a set of audit procedures. A written audit Program begins with
the recognition of specific objectives followed by specification of procedure design to

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produce sufficient competent evidential matter. An audit Program acts as a guide to arrange
and distribute the work and also to check work against the possibility of omissions. Auditor
should first prepare the preliminary audit Program for compliance testing of internal
accounting control systems and substantive testing of accounting balance. After obtaining a
thorough understanding of the client‘s business, the auditor formulates an overall audit
strategy for the engagement at hand.
Types of Audit Program: Following are the two types of audit Program –Fixed AND
Flexible
Fixed Audit Program − Audit staff has to follow the instructions mentioned in the Audit
Program as laid down in it without any change. Even all are not applicable to that particular
organization in a particular situation. Fixed audit Program is very rigid in nature and any
modification or change is Program is not easily possible.
Flexible Audit Program − Flexible Audit Program gives only the outline of the scope and
the procedures to be followed instead of any fixed audit instructions. Therefore an Auditor
has a choice to develop, adopt and modify an Audit Program as per the needs and
requirements depending on the internal control system and other situations of that particular
organization.
Advantages of Audit Program
The following are the advantages of audit Program;
• Audit Program gives complete coverage of audit work that can be performed by the

audit staff.
• Audit Program works as a road map for the upcoming years and the audit staff can
refer to this and understand the future course of action.
• Audit Program enhances the efficiency of the audit assistants as they are very clear
about their duties.
• Audit is more systematic through audit Program.
Disadvantages of Audit Program
The following are the disadvantages of audit Program −
1. It is not of great help to small business units.
2. Audit becomes mechanical and inefficient audit assistant may also take shelter
behind the audit Program.

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 3. Audit Program cannot be applied in uniformity to all business units as audit work of
all organization cannot be the same.
Generally, auditors perform auditing based on the following steps:
1. Engagement - When a new client hires an auditor, the auditor first examines the client
company. The auditor studies the company's ethical background and history. Successful
auditors are always associated with ethics and professionalism. It is foolish for an
auditor to work for a client that has ethical issues in the past. Auditors also ensure that
they are totally independent from the client before accepting them. If the auditing firm
has a partner that was once a manager in the company, for example, if the audit firm and
the company are related, there might be serious independence issues. Once the auditor
decides to accept the client, he drafts an agreement stating the terms of the audit and
other details, such as remuneration.
2. Understanding the company - Auditors study the industry and business environment
of the company. Auditors must understand how the business works, the procedures of
the company, and so on.
3. Assess risks the auditor assesses the risks of the company, and decides on what is
considered material or immaterial.
4. Develop audit plan the auditor finally plans which areas of the business he will focus
on and how much time will be spent for the audit.
5. Collect evidence and test internal control systems - The auditor starts collecting
evidence to verify the financial records, using a wide range of tools. It might involve
interviews, observations, tests, calculations, confirming with a professional expert on
some area, and so on. Auditors also review and conduct the company's internal control
system. A good and proper internal control system probably means that proper financial
records will be produced.
6. Conclusion and issuance of the auditor's report - The auditor issues his / her
conclusion in the auditor's report based on the findings objectively.

3.4. Audit Working Paper

During the course of audit, auditors should maintain all relevant documents and records in
the form of both hard and soft copy called audit working papers. Audit working papers are

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those papers which contain essential facts about accounts which are under audit. The audit
working papers contains the file of all analysis, summaries, comments, and correspondence
built up by the auditors during the course of the fieldwork of an audit engagement. It is the
duty of auditors to maintain audit working papers as they support the audit report.
The audit working papers provide the following purposes to the auditor:
a. To show the extent to which accounting principles and auditing standards have been
adhered.
b. To provide essential support for the auditors‘ opinion including evidence that the
examination was conducted in accordance with GAAS.
c. To reveal how the work was performed by the audit staff and thus helps to the auditors
in forming an opinion about their efficiency.
d. To assist auditors in justifying their position against criticism and can be serve as legal
evidence if the legal action is brought against the auditors due to negligence in
performing the audit work.
e. Help auditors in finalizing the audit report without much delay.
f. They enable the auditors to know the weakness of the internal check system in operation
and the inefficiency of the accounting system, if any. The auditors may advice to their
client about ways and means to improve inefficiencies.
g. They serve as a guide to the auditors for audits of the same client in the succeeding
years.

Working papers should be carefully prepared as they are the bases of conclusions and
summarizations shown by the auditor in his/her report. As such, they should be clear and
significant matter which require strategic judgment together with the auditor‘s conclusions
complete and contain all essential information sufficiently so that they may be of greater
utility. Each complete working paper should be signed and dated by the persons performing
the work. This will help in fixing responsibilities. They should be properly organized,
arranged, and documented.
General working paper preparation guidelines
 Working papers must be clean, neat, and legible

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 All questions and exceptions noted in the working papers should be resolved, hopefully
before the end of the field work, and carefully before the report is issued.
 Only statements of fact and professional judgment should appear on the working papers.
 Brackets should be used to show negative numbers instead of red ink.
 Time should be economized as much as possible in the preparation of working papers.
This can be achieved by assigning some work papers to be prepared for the auditor By
the Client‘s employee /PBC/, which are then examined by the auditor. Another way to
save time is by analyzing balance sheet accounts and their related income instatement
accounts together on the same work paper.
Working papers should be stored/filed/ in a secure place and protected from unauthorized
use. Current technology allows for working papers to be stored electronically on computers,
CDS, flash, etc. Working papers should be stored for as long as the auditor has a potential
liability for the financial statement opinions, which the work papers support. The Ethiopian
commercial code of 1960 requires that organizations, which come under its rules, keep
books of accounts and accounting documents for ten years after the last entry.
Ownership of working papers
A pertinent question arises as to whom the owner of these working papers. The auditor
claims the possession on grounds that he/she has collected the information for the purpose
of discharging his/her duties. He/she further argues that if a suit is being filed by the client
against him/her for negligence in the performance of his/her duties, these working papers
can be furnished as evidence to show the exact work done by him/her. These papers can be
produced by the auditor to defend him/her. As such, these working papers should not be
handed over to the client even after the audit ceased. On the other hand, the client claims
that since the auditor act as its agent, he/she has no right to keep these papers with him/her.
However, they also permit to see the following cases to solve these controversies. In the
first case, it was held that the working papers belonging to the auditor because they were
independent contracts and not agent of the client. In the second case, it was held that the
working papers prepared by the auditor for the sole purpose of producing financial
statements belonged to the auditor and not to the client. It can therefore, be concluded that
the working papers prepared by the auditor or his/her staff to carry out the assignments are
his/her property and the client has no claim on such papers.

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Finally, audit working papers are confidential in nature. The information collected by the
auditor or his/her staff should not be exposed to any unrelated party other than his/her client
without the consent of his/her client or otherwise than as required by any law for the time
being in force. Thus the auditor should always impress up on his/her staff to maintain
complete secrecy with regard to the working papers.

3.5. Audit Risk

In the audit planning process, the auditor should ordinarily established levels of planning
materiality such that the audit work will be sufficient to meet the audit objectives and will
use audit resources efficiently. For example, in the review of an existing system the auditor
will evaluate materiality of the various components of the system in planning the audit
program for the work to be performed. The auditor should consider both qualitative and
quantitative aspects in determining materiality. The main purpose of an audit is to express
an opinion on the truth and fairness of the financial statements. The concept of materiality
affects the nature and size of audit tests. The auditor designs audit procedures to verify if
financial statement items are free of material error and irregularities. If financial statement
audit, due to cost and time only selected transactions are examined, this implies accepting
errors in the financial statements to remain undetected. However, even 100% checking does
not guarantee 100% accuracy. Therefore, either the whole transactions or selected
transaction are checked, there is certain level of risk. Thus, the auditor‘s main concern in the
financial statement audit is to minimize risk and to ensure that no material error remains
undetected.

An assessment of risk should be made to provide reasonable assurance that all material
items will be adequately covered during the audit work. This assessment should identify
areas with relatively high risk of existence of material problems. Audit risk is the risk that
the auditor will issue an inappropriate opinion on the accounts. Or it is the risk that the
auditor gives unqualified opinion on the financial statements when he/she should have
qualified opinion on the financial statements when he/she should have qualified opinion.

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It is the chance that material misstatements exist in the financial statements and the auditors
do not detect the misstatements with their audit procedures. Audit risk is the chance that:
I. A material misstatement in an assertion has occurred and
II. The auditors do not detect the misstatement
Audit risk has three components namely inherent risk, control risk, and detection risk.
Inherent Risk: refers to the susceptibility of an account balances to material error assuming
the client does not have any related internal controls.
Control Risk: is the risk that a material misstatement in an account balance will not be
prevented or detected on a timely basis by the company‘s internal control.
Detection Risk: is the risk that auditor‘s procedures for verifying account balances will not
detect a material error when in fact such error exists. It is the risk that the auditor‘s
procedures will lead them to conclude that a material misstatement does exist. Therefore,
detection risk is directly related to the effectiveness of the auditor‘s procedures. While
inherent and control risk are functions of the client and its environment. In planning the
audit, the auditor should assess the extent of inherent and control risk and then plan relevant
audit procedures to the effectiveness of the auditor‘s procedures. In planning the audit, the
auditor should assess the extent of inherent and control risk and then plan relevant audit
procedures to reduce detection risk to the level tolerable. This turn helps auditors to reduce
the overall audit risk so as to issue an appropriate opinion.

3.6. Materiality
Materiality and audit risk are related both must be considered in the planning stage so as to
determine the extent, timing, and nature of the examination. For planning purpose,
materiality is the auditor‘s preliminary estimate of the smallest amount misstatements that
would affect the judgment of a reasonable person relying up on the financial statements.
Assessing the level of materiality of misstatement would help auditors to appropriately
modify their opinions whenever there are material deficiencies in the client‘s financial
statements. However, they may issue unqualified report if the deficiencies are immaterial.
Assessing level of materiality of misstatements in the financial statement items means
evaluating as to whether the financial statements contain material misstatements or not.

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Chapter Summary
Planning the audit includes establishing the overall audit strategy for the engagement and
developing an audit plan, which includes, in particular, planned risk assessment procedures
and planned responses to the risks of material misstatement. Planning is not a discrete phase
of an audit but, rather, a continual and iterative process that might begin shortly after (or in
connection with) the completion of the previous audit and continues until the completion of
the current audit. The auditor should develop and document an audit plan that includes a
description of the planned nature, timing, and extent of the risk assessment procedures; the
planned nature, timing, and extent of tests of controls and substantive procedures and other
planned audit procedures required to be performed so that the engagement complies with
standards.

Glossary of Terms
Audit Plan is the specific guideline to be followed when conducting an audit.
Audit program a list of examination and verification steps to be applied set out in such a
way that the inter-relationship of one step to another is clearly shown and designed, keeping
in view the assertions discernible in the statement of account produced for audit or on the
basis of an appraisal of the accounting records of the client.
Audit Risk (also referred to as residual risk) refers to the risk that an auditor may issue an
unqualified report due to the auditor's failure to detect material misstatement either due to
error or fraud.
Materiality is the threshold above which missing or incorrect information in financial
statements is considered to have an impact on the decision making of users.
Audit working paper the documents which record during the course of audit evidence
obtained during statements auditing, internal management auditing, information systems

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auditing, and investigations and used to support the audit work done in order to provide the
assurance that the audit was performed in accordance with the relevant auditing standards.

Chapter Review Questions 3

Part I: Write ‘’TRUE’’ if the statement is correct and ‘’FALSE’’ otherwise.
1. Auditor must adequately plan the work and must properly supervise any assistants,
obtain a sufficient understanding of the entity and its environment, including its internal
control, to assess the risk of material misstatement of the financial statements.
2. Audit program refers to the detail list of the audit procedures during the audit time.
3. According to the field work standards of GAAS, the audit work shall be done arbitrary.
4. Materiality is the threshold above which missing or incorrect information in financial
statements is considered to have an impact on the decision making of users.
5. Audit risk refers to the risk that an auditor may issue an unqualified report due to the
auditor's failure to detect material misstatement either due to error or fraud.

Part II: Choose the correct answer for the following multiple choice questions.
1. The audit working papers provide the following purposes to the auditor, except;
A. To show the extent to which accounting principles and auditing standards have
been adhered.
B. To reveal how the work was performed by the audit staff and thus helps to the
auditors in forming an opinion about their efficiency.
C. They enable the auditors to know the weakness of the internal check system in
operation and the inefficiency of the accounting system, if any.
D. They serve as a guide to the auditors for audits of the same client in the succeeding
years.
E. None of the above
2. All of the following are the audit planning process except:
A. Obtained back ground information

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 B. Obtain information about client‘s legal documents
C. Schedule the audit work
D. Assigning professional staff to engagement.
E. None of the above
3. The chance that material misstatements exist in the financial statements and the auditors
do not detect the misstatements with their audit procedures is;
A. Audit Risk
B. Audit plan
C. Materiality
D. Detection risk
E. All of the above
4. The detailed instruction for the collection of a type of audit evidence that is to be
obtained at some time during the audit is;
A. Audit planning
B. Audit program
C. Audit strategy
D. Audit Procedure
E. None of the above
5. The objectives of preparing audit program are:
A. To assist in planning the audits
B. To provide a record of the work done and the conclusions drawn.
C. Serve as a basis for effective quality control and to meet audit evidence
requirements.
D. All of the above
E. None of the above

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