Nature, Objective & Scope of Audit

NATURE, OBJECTIVE AND

Chapter 01 SCOPE OF AUDIT

1 ORIGIN OF AUDITING
Kautilya’s Arthshastra (4th century BC) - Reference to auditing is found where
it talks about fixed accounting year, a process for closure of accounts and audit
for the same. Even there are references to misstatements in financial statements
(FS) due to abuse of power.

Origin of word “AUDIT” (Medieval times – 1100 to 1500 AD)

Auditors used to hear the accounts read out to them to check that employees were

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not careless and negligent. This lead to use of word audit originating from Latin
word “audire” meaning “to hear”.

Industrial revolution in Europe (Late 18th / Early 19th Century)

Led to astronomical expansion in volume of trade and consequently demand of
auditors.

Auditor of Government Entities in India (1860)

The first Auditor General of India was appointed in British India in 1860 having
both accounting and auditing functions. Later on, office of Auditor General was
given statutory recognition. Presently, Comptroller and Auditor General of India
(C&AG) is an independent constitutional authority responsible for auditing govern-
ment receipts and expenditures.

Institute of Chartered Accountants of India (1949)

It was established as a statutory body under an Act of Parliament in 1949 for
regulating the profession of Chartered Accountancy in the country.

2 MEANING AND NATURE OF AUDITING

“An audit is an independent examination of financial information of any entity,
whether profit oriented or not, and irrespective of its size or legal form, when such
an examination is conducted with a view to expressing an opinion thereon”.

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Analysis

A Audit is an independent examination of financial information

 Meaning of Independence - Judgement of a person is not subordinate to the wishes or
direction of another person who might have engaged him.
 The auditor should be independent of entity underEtaudit to form opinion without any in-
fluence.
 Independence increases its ability to act objectively without any biases.
 Example, Auditor appointed by a company which is owned managed by his brother or
company where he has invested in shares of the company, auditor should not
accept as his own self-interest gets involved.

B Audit can be of entity that is a

 Business or a non-profit organization like an NGO or a charitable trust.
 Small, medium or large organisation.
 Any entity with any legal structure i.e. proprietary concern, a partnership firm, a LLP, a
private company, a public company, a society or a trust.

C The purpose of audit is to express an opinion on the FS.

Preparation and presentation of FS of an entity is responsibility of management.

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The auditor expresses an opinion on FS by means of written audit report.

D Auditor to check that FS are not misleading anybody

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He ensures that – (FS as per books → Supported by evidences → Nothing Omit →
Clearly → Class, disclosure, description as per AS → T&F View)
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 the accounts have been drawn up with reference to entries in the books of account;
 the entries in the books of account are adequately supported by sufficient and ap-
propriate evidence;
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 none of the entries in the books of account has been omitted in the process of compilation;
 the information conveyed by the statements is clear and unambiguous;
 FS amounts are properly classified, described and disclosed in conformity with ac-
counting standards; and
 the statement of accounts presents a true and fair picture of the operational results
and of the assets and liabilities.

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 Nature, Objective & Scope of Audit

Auditing provides assurance. Its basic nature lies in providing assurance to users -
providing confidence to users of FS. Such an assurance lends credibility to FS.

3 AUDITING- RELATIONSHIP WITH OTHER DISCIPLINES

Auditing is interdisciplinary in nature and draws as well as make use of different
subjects. An auditor is required to have sound understanding of:
Accounting Auditing reviews the FS which are nothing but a result of the
overall accounting process hence a sound knowledge of accounting
principles is required.

Law An auditor should have a good knowledge of business laws and

taxation laws affecting the entity.

Economics Auditor is expected to be familiar with the overall economic

environment of the client in which the business is operating.
Behavioural Knowledge of human behaviour as auditor has to interact with
Science people for seeking information and making inquiries.

Statistics Knowledge of statistical sampling for meaningful conclusions.

Auditors uses statistical methods to draw samples in a scientific
f Jamie manner. It is not possible for an auditor to check each and every
transaction. So, use of statistical methods to draw samples for
conducting audit is made.
Financial Auditor is expected to have knowledge about various financial
Management techniques such as working capital management, funds flow, ratio
analysis, capital budgeting etc. These also assist in applying some
audit procedures effectively. Knowledge of financial market is also
expected from auditor.

Mathematics For verification of inventories and other checks.

Data EDP auditing in itself is developing as a discipline in itself.
Processing
Good auditor is one who understands the client and his business
Production
functions such as production, cost system, marketing etc.

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4 OBJECTIVES OF AUDIT
SA-200 “Overall Objectives of the Independent auditor and the conduct of an audit
in accordance with Standards on Auditing”

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In conducting audit of FS, objectives of auditor are: -
(a) To obtain reasonable assurance about whether the FS as a whole are free from
material misstatement, whether due to fraud or error, thereby enabling the
auditor to express an opinion on whether the FS are prepared, in all material
respects, in accordance with an applicable financial reporting framework; and

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(b) To report on the FS, and communicate as required by the SAs, in accordance
with the auditor’s findings.

Analysis

 Reasonable assurance is to be distinguished from absolute assurance.

Absolute assurance is a complete assurance or a guarantee that FS are free from
material misstatements.
However, reasonable assurance is not a complete guarantee. Although it is a high-
level of assurance but it is not complete assurance.
 Audit is carried out with professional competence and skills in accordance with
Standards on Auditing.
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Audit procedures are applied in accordance with SAs, audit evidence is obtained and evaluated.
On basis of that, conclusions are drawn and opinion is formed.
It leads to high level of assurance which is called as reasonable assurance but it is
not absolute assurance.
 Misstatements in FS can occur due to fraud or error or both
The auditor seeks to obtain reasonable assurance whether FS as a whole are free

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from material misstatements caused by fraud or error.
He has to see effect of misstatements on FS as a whole, in totality.
 Opinion - FS as per applicable FRFW
Obtaining reasonable assurance that FS as a whole are free from material misstate-
ments enables the auditor to express an opinion on whether the FS are prepared, in
all material respects, in accordance with an applicable financial reporting framework.
 Audit Report – As per findings
The opinion is reported and communicated in accordance with audit findings through
a written report as required by SAs.

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 Nature, Objective & Scope of Audit
5 SCOPE OF AUDIT
(Scope refers to range or reach of something)

Purpose of an audit
To enhance the degree of confidence of intended users in the FS.
It is achieved by the expression of an opinion by the auditor on
whether the FS are prepared, in all material respects, in accord-
ance with an applicable financial reporting framework.

Users of FS
May be shareholders, employees, customers, government and
regulatory authorities, bankers etc.

Applicable financial reporting framework

Framework adopted in the preparation and presentation of the FS,
acceptable in view of the nature of the entity and the objective of
the FS, or that is required by law or regulation.
Example, in case of companies in India, financial reporting frame-
work is provided under Schedule III of Companies Act,2013.

A SCOPE OF AUDIT- WHAT IT INCLUDES

Scope of audit of FS:

(1) Coverage of all aspects of entity
All aspects of the entity relevant to the FS being audited are covered under audit.
(2) Reliability and sufficiency of financial information

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By study and assessment of accounting systems and internal controls and by car-
rying out appropriate tests, enquiries and procedures auditor verifies information
contained in underlying accounting records and other source data (like bills, vouch-
ers, documents etc.) is reliable and sufficient basis for preparation of FS.
(3) Proper disclosure of financial information

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FS should properly summarize transactions and events recorded therein. FS to
consider the judgments made by management in preparation of FS. For example,
choosing of appropriate accounting policies in relation to various accounting issues
like choosing method for valuation of inventories.
(4) Expression of Opinion on historical financial information
Auditor evaluates selection and consistent application of accounting policies by

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management. FS of an entity are prepared on historical financial information basis
hence audit is also based on historical financial information.
“Historical financial information” means information expressed in financial terms in
relation to a particular entity, derived primarily from that entity’s accounting sys-
tem, about economic events occurring in past time periods or about economic condi-
tions or circumstances at points in time in the past.

B SCOPE OF AUDIT- WHAT IT DOES NOT INCLUDES

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 Responsibility of preparation and presentation of FS – Lies with Management
 Duties outside scope of competence of auditor - Auditor is not expected to perform
duties which fall outside domain of his competence, like:
 Physical condition of certain assets like that of sophisticated machinery
 Suitability and life of civil structures like buildings
 Expertise in authentication of documents - The genuineness of documents cannot be
authenticated by him because he is not an expert in this field.
 Investigation - Audit is distinct from investigation.

INVESTIGATION Vs AUDIT
 An audit is not an official investigation into alleged wrong doing.
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 Auditors do not have any specific legal powers of search or recording statements of
witness on oath necessary for carrying out an official investigation. pay
 Investigation is a critical examination of the accounts with a special purpose. For Targeted
example, if fraud is suspected and it is specifically called upon to check the accounts
whether fraud really exists, it takes character of investigation.

D
whole are free from material misstatement, whether due to fraud or error, thereby
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The objective of audit, is to obtain reasonable assurance about whether the FS as a
Gopinion
enabling the auditor to express an opinion.
 The scope of audit is general and broad whereas scope of investigation is specific and narrow

6 INHERENT LIMITATIONS OF AUDIT

not absolute assurance
give
Certain inbuilt limitations due to which an auditor cannot obtain an absolute assur-
ance that FS are free from misstatement due to fraud or error. These fundamental
limitations arise due to the following factors:

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 Nature, Objective & Scope of Audit
A Nature of financial reporting
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 Preparation of FS involves making many judgments by management.

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 Management prepared FS free from material misstatements and devises internal
controls. Such controls also suffer from own limitations like lapse of control due to
collusion of employees.

B Nature of Audit procedures

 The auditor carries out his work by obtaining audit evidence through performance
of audit procedures.
 However, there are practical and legal limitations to obtain audit evidence like use of
sample testing or sometimes management may not provide complete information as

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requested by auditor and auditor cannot force them, an example of legal limitation.
 The management may indulge in frauds and conceal it to make it hard to detect
by the auditor. It may produce fabricated documents to auditor. An auditor may
not be an expert to detect unauthenticated documents
 Entity may have entered into some transactions with related parties only paper
and auditor may not be able to detect probable wrong doings in such transactions.

C Not in nature of investigation

 Audit is not an official investigation. Hence, auditor cannot obtain absolute assur-
ance that FS are free from material misstatements due to frauds or errors.

D Timeliness of financial reporting and decrease in relevance of information over time

 The relevance of information decreases over time and auditors cannot verify each
and every matter.

E Future events

The business may cease to exist in future due to changes in market conditions, emer-
gence of new business models or products or due to onset of some adverse events.
In view of the above factors, an auditor cannot provide a guarantee that FS are free
from material misstatements due to frauds or errors.

7 WHAT IS AN ENGAGEMENT?
 Engagement means an arrangement to do something.

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 In audit, it means a formal agreement between auditor and client under which
auditor agrees to provide auditing services.
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 It takes the shape of an engagement letter.

External audit engagements

The purpose of external audit engagements is to enhance the degree of confidence

of intended users of FS. Such engagements are also reasonable assurance engage-
ments. For example, in India, companies are required to get their annual accounts
audited by an external auditor. Even non-corporate entities may choose to have
their accounts audited by an external auditor because of benefits of such an audit.

8 BENEFITS OF AUDIT-WHY AUDIT IS NEEDED?

 Confidence to users that information on which they are relying is qualitative and as
per globally recognized Standards.
 Shareholders interest Eis safeguarded by an audit of FS prepared by management.
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 Moral check on employees for the fear of discovering frauds by audit.
 Audited FS are helpful to government authorities for determining tax liabilities. Gout
 Audited FS can be relied upon by lenders, bankers for making their credit decisions
fund Boviders
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i.e. whether to lend or not to lend to a particular entity.
 An audit may also detect fraud or error or both.
 An audit reviews existence and operations of controls operating in any entity. Control
Hence, it is useful at pointing out deficiencies.

9 AUDIT- MANDATORY OR VOLUNTARY?

Companies Act – Every company to get its accounts audited Alles

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IT Act – Audit needed if turnover crosses specified limits

ESchool / Colleges, etc – Audit pre-requisite for availing grants from the Government.
Audit is not always mandatory. Many entities may get their accounts audited volun-
tarily because of benefits from the process of audit. Many such concerns have their
internal rules requiring audit due to advantages flowing from an audit.

10 WHO APPOINTS AN AUDITOR?

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Company - Appointed by members (shareholders) in Annual General Meeting (AGM).
Government companies - Appointed by C&AG, an independent constitutional authority.

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 Nature, Objective & Scope of Audit

Firm - Auditor is appointed by partners of firm.

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Government Authority – Law may require to appoint auditor by government authorities.

11 TO WHOM REPORT IS SUBMITTED BY AN AUDITOR?

The outcome of an audit is written audit report with his opinion. The report is sub-
mitted to person making the appointment.
Example: Companies – Shareholders; Firm – Partners who have engaged him.

12 ASSURANCE ENGAGEMENT
“Assurance engagement” means an engagement in which a practitioner expresses

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a conclusion designed to enhance the degree of confidence of the intended users

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other than the responsible party about the outcome of the evaluation or measure-
ment of a subject matter against criteria.

A Elements of an Assurance Engagement

Following elements comprise an assurance engagement: -

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Parties – 3 party - Practitioner, Responsible Party, and Intended Users
A practitioner is a person who provides the assurance (could be auditor of historical
financial information of report on prospective information).
A responsible party is the party responsible for preparation of subject matter.
Intended users are the persons for whom an assurance report is prepared.

2 Subject matter
It refers to the information to be examined by the practitioner. For example,
financial information contained in FS while conducting audit of FS.

3 Suitable criteria
These refer to benchmarks used to evaluate the subject matter like standards, guid-
ance, laws, rules and regulations.

4 Sufficient appropriate evidence

“Sufficient” - Quantity of evidence obtained by auditor.
“Appropriate” - Quality of evidence obtained by auditor. I
One evidence may be providing more comfort to auditor than the other evidence.

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The evidence providing more comfort is qualitative and, therefore, appropriate. Evi-
dence should be both sufficient and appropriate.

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A written assurance report in appropriate form
A written assurance report is the outcome of an assurance engagement.

B Meaning of Review; Audit Vs. Review

Audit is a reasonable assurance engagement. However, Review is a limited assurance

engagement. It provides:
 lower level of assurance than audit, and

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 is based on fewer procedures; and

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 is useful for drawing limited conclusions.
Both are based on historical financial information.

C Types of Assurance Engagements- Reasonable assurance engagement vs. Limited

assurance engagement

And
Reasonable assurance engagement

Reasonable assurance engagement

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Limited assurance engagement

Limited assurance engagement provides

provides high level of assurance. lower level of assurance than reasonable
assurance engagement.

It performs elaborate and extensive It performs fewer procedures as compared

procedures to obtain sufficient appro- to reasonable assurance engagement.
priate evidence.

It draws reasonable conclusions on the It involves obtaining sufficient appropri-

basis of sufficient appropriate evidence. ate evidence to draw limited conclusions.

Example of reasonable assurance en- Example of limited assurance engage-

gagement is an audit engagement. ment is review engagement.

D Prospective financial information

“Prospective financial information” means financial information based on as-
sumptions about events that may occur in the future and possible actions by an

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entity. It can be in the form of a forecast or projection or combination of both.
 Nature, Objective & Scope of Audit

“Historical financial information” Vs “Prospective financial information.”

6HFI - Information expressed in financial terms of an entity about economic events,

conditions or circumstances occurring in past periods. This is rooted in past events
PFI - Financial information based on assumptions about occurrence of future events
and possible actions by an entity. This is rooted in future events.

Assurance Reports Involving Prospective Financial Information

Practitioner obtains sufficient appropriate evidence that:
 management’s assumptions on which the prospective financial information is
based are not unreasonable,
 the prospective financial information is properly prepared based on the assumptions; and
 it is properly presented and all material assumptions are adequately disclosed.

Prospective financial information relates to future events hence auditor cannot ex-
press an opinion as to whether the results shown in the prospective financial infor-
mation will be achieved. Hence, practitioner provides a report assuring that nothing
has come to practitioner’s attention to suggest that these assumptions do not
provide a reasonable basis for the projection, providing only a “moderate” level of
assurance.

Examples of assurance engagements

Example of engagement assurance Type of assurance engagement

Audit of financial statements
Review of financial statements

Examination of Prospective financial

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Reasonable assurance engagement
Limited assurance engagement
Provides assurance regarding reason-
ability of assumptions forming basis of
information
Ierelated matters
projections and
Report on controls operating at an Provides assurance regarding design and
organization operation of controls
on
13 QUALITIES OF AUDITOR
 Personal qualities - Tact, caution, firmness, good temper, integrity, discretion,
industry, judgement, patience, clear headedness, and reliability are qualities which

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an auditor should have. In short, all personal qualities that make a good businessman.
 Shine of culture for attaining a great height.
 Highest degree of integrity backed by adequate independence.
 Basic human qualities of being trustworthy.
 Expert and exhaustive knowledge of accounting in all its branches is the sine qua
non of the practice of auditing. He must know thoroughly all accounting principles
and techniques.

14 ENGAGEMENT AND QUALITY CONTROL STANDARDS: AN OVERVIEW

The following Standards issued under authority of ICAI Council are collectively
known as Engagement Standards: -
 Standards on auditing (SAs) which apply in audit of historical financial information.
 Standards on review engagements (SREs) which apply in review of historical

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financial information.
 Standards on Assurance engagements (SAEs) which apply in assurance engage-
ments other than audits and review of historical financial information.
 Standards on Related Services (SRSs) which apply in agreed upon procedures to
information, compilation engagements and other related service engagements.
The purpose of issue of these standards is to establish high quality standards and
guidance in the areas of FS audits and in other types of assurance services.

Limitations only live in our

minds. But if we use our
imagination, our possibilities
become limitless.

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 Nature, Objective & Scope of Audit

Engagement Standards

Standards on auditing Standards on review Standards on Assurance Standards on Related

(SAs) engagements (SREs) engagements (SAEs) Services (SRS)

Apply in agreed
Apply in assurance upon procedures to
Apply in audit of engagements other
Apply in review of information,
historical financial than audits and review
historical financial compilation
information by in- of historicalfinancial
information. engagements and
dependent auditor. information. other related ser-
vice engagements.

For example, an en-

Covers overall objec- Review is a limit- gagement to perform
Assurance engage-
tives of independent ed assurance en- certain procedures
ments, examination
auditor, audit docu- gagement, hence concerning individu-
is not of historical
mentation, planning involves fewer pro- al items of financial
financial information
an audit, identifying cedures than audit. data, say, accounts
or may relate to pro-
and assessing risk of Since it provides payable, accounts
viding assurance re-
material misstate- assurance to users, receivable, purchas-
garding non-financial
ment, audit sampling, it involves obtaining esfrom related parties
matters like design
audit evidence and SAAE. Eg. Review and salesand profits
and operation of in-
forming an opinion of interim financial of a segment of an
ternal control in an
and reporting on FS. information of an entity, or a FS, say, a
entity.
entity. balance sheet or even
a complete set of FS.

SA 200 to 800 series SRE 2000 series SAE 3000 series SRS 4000 Series

Standards on Quality Control

 Standards on Quality Control (SQCs) have been issued to establish standards and
provide guidance regarding a firm’s responsibilities for its system of quality control
 It covers quality control of audit and review of historical financial information and
for other assurance and related service engagements.
 SQC 1 has been issued in this regard.

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 It requires auditors/practitioners to establish system of quality control so that firm
and its personnel comply with professional standards and regulatory & legal require-
ments and reports issued are appropriate.
 Its basic objective is that while rendering services, to which engagement standards
apply, there should be a system of quality control with in firms to ensure complying
with professional standards/legal requirements.
 System of quality control ensures issuing of appropriate reports in the circumstances.

Why are Standards needed?

 Standards ensure carrying out of audit against established benchmarks at par with
global practices.
 Standards improve quality of financial reporting thereby helping users to make dili-
gent decisions. E
 Standards promote uniformity as audit of FS is carried out following these Standards.
 Standards equip professional accountants with professional knowledge and skill.
 Standards ensure audit quality.

Duties in relation to Engagement and Quality Control Standards

 It is the duty of professional accountants to see that Standards are followed in en-
gagements undertaken by them.
 However, a situation may arise when a specific procedure as required in Standards
would be ineffective in a particular engagement.
 In such a case, he is required to document how alternative procedures performed
achieve the purpose of required procedure.
 Also, reason for departure has also to be documented unless it is clear. Further, his
report should draw attention to such departures.
 It is also to be noted that a mere disclosure in the report does not absolve a profes-
sional accountant from complying with applicable Standards.

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