CHAPTER ONE

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

Definition of auditing
Auditing is defined as the accumulation and evaluation of evidence about information to
determine and report on the degree of correspondence between the information and established
criteria. Auditing should be done by a competent independent person. This description of
auditing includes several key words and phrases. Each of them is discussed in this section
briefly.
 Information and established criteria: To do an audit, there must be information in a
verifiable form and some standards [criteria] by which the auditor can evaluate the
information. Information can and does take many forms. Auditors routinely perform audits of
quantifiable information, including companies’ financial statements and individuals’ federal
income tax returns. Auditors also perform audits of more subjective information, such as the
effectiveness of computer systems and the efficiency of manufacturing operations. The
criteria for evaluating information also vary depending on the information being audited.
 Accumulating and evaluating evidence: Evidence is defined as any information used by
the auditor to determine whether the information being audited is in accordance with the
established criteria. Evidence takes many different forms, including oral testimony of the
audited, written communication with outsiders, and observations by the auditor. It is
important to obtain a sufficient quality and volume of evidence to satisfy the purpose of the
audit.
 Competent, independent person: The auditor must be qualified to understand the criteria
used and competent to know the types and amount of evidence to accumulate to reach the
proper conclusion after the evidence has been examined. The auditor also must have an
independent mental attitude. It does little good to have competent person who is biased
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 performing the evidence accumulation when unbiased information and objective thinking are
needed for the judgments and decisions to be made.
 Reporting: The final stage in the audit process is the audit report, which is the
communication of the findings to users. Reports differ in nature, but in all cases they must
inform readers of the degree of correspondence between information and established criteria.
Reports also differ in form and can vary from the highly technical type report usually
associated with financial statement audits to a simple oral report in the case of an operational
audit done of a small department’s effectiveness.

1.1 DISTINGUISHING BETWEEN ACCOUNTING AND AUDITING

Accounting Auditing of financial statement
Is the process of identifying ,measuring, recording Is the process of obtaining and evaluating
and communicating economic information about evidences and determining the fairness of financial
an organization in conformity with GAAP statement inconformity with GAAS
Deliver financial statements to users Deliver audit report(opinion) to users
Precede auditing Begins when accounting ends
No prescribed qualification is legally required for The auditor must be chartered accountant(CPA)
the accountant
All accountant may not have auditing knowledge Auditors must have accounting knowledge
An accountant is an employee of the firm An auditor is independent professional
Constructive and theoretical Critical aspect of accounting and analytical in
nature
Generally appointed by management and expected Appointed by the shareholders or audit committee
to perform according to the rule and regulation set of the organization and is independent
by management

1.2 ASSURANCE SERVICES

Assurance services are independent professional services that improve the quality of information
for the decision makers. Individuals who are responsible for making business decisions seek
assurance services to help improve the reliability and relevance of the information used as bases
for their decisions. Assurance services are valued because the assurance provider is independent
and perceived as being unbiased with respect to the information examined.

Assurance services can be performed by many CPAs or by a variety of other professionals. For
example, consumer union is a nonprofit organization that tests a wide variety of products used by
consumers and reports there evaluation of the quality of the products tested in consumer reports.
The information provided in consumer report intended to help consumers make intelligent
decisions about the products they buy. The information provided in consumer reports is
considered more reliable by many consumers then information provided by the manufacturers’
because consumer union is independent of the product manufacturers.

The need for assurance services is not new. CPAs have provided many assurance services for
years, particularly assurance about historical Financial
Statement Information. CPA firms have also performed assurance services related to lotteries
and contests to provide assurance that winners were determine in an unbiased fashion in
accordance with contest rules. More recently, CPAs have been expanding the types of assurance

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services they perform to include engagements that provide assurance about other types of
information, such as assurance about company financial forecasts and website controls. The
demand for assurance services are expected to grow as the demand for forward looking
information increases and as more real-time information becomes available through the internet.

Attestation services
One category of assurance services provided by CPAs is attestation services. An attestation
service is a type of assurance service in which the CPA firm issues a report about the reliability
of an assertion that is made by another party. Attestation services fall into five categories:
1. Audit of historical financial statements
2. Audit of internal control over financial reporting
3. Review of historical financial statements
4. Attestation services on information technology
5. Other attestation services that may be applied to a broad range of subject matter

Audit of Historical Financial Statements In an audit of historical financial state - ments,

management asserts that the statements are fairly stated in accordance with applicable country or
international accounting standards. An audit of these statements is a form of attestation service in
which the auditor issues a written report expressing an opinion about whether the financial
statements are fairly stated in accordance with the applicable accounting standards. These audits
are the most common assurance service provided by CPA firms.
Audit of Internal Control over Financial Reporting For an audit of internal control over
financial reporting, management asserts that internal controls have been developed and
implemented following well established criteria. Section 404 of the Sarbanes–Oxley Act requires
public companies to report management’s assessment of the effectiveness of internal control.
The Act also requires auditors to attest to the effectiveness of internal control over financial
reporting. This evaluation, which is integrated with the audit of the financial statements,
increases user confidence about future financial reporting, because effective internal controls
reduce the likelihood of future misstatements in the financial statements.

Review of Historical Financial Statements For a review of historical financial statements,

management asserts that the statements are fairly stated in accordance with accounting standards,
the same as for audits. The CPA provides a lower level of assurance for reviews of financial
statements compared to a high level for audits, therefore less evidence is needed. A review is
often adequate to meet financial statement users’ needs. It can be provided by the CPA firm at a
much lower fee than an audit because less evidence is needed. Many nonpublic companies use
this attestation option to provide limited assurance on their financial statements without incurring
the cost of an audit.

Attestation Services on Information Technology For attestations on information technology,

management makes various assertions about the reliability and security of electronic information.
Many business functions, such as ordering and making payments, are conducted over the Internet
or directly between computers using electronic data interchange (EDI). As transactions and
information are shared online and in real time, businesspeople demand even greater assurances
about information, transactions, and the security protecting them. WebTrust and SysTrust are
examples of attestation services developed to address these assurance needs.

Other Attestation Services CPAs provide numerous other attestation services. Many of these
services are natural extensions of the audit of historical financial statements, as users seek
independent assurances about other types of information. In each case, the organization being
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audited must provide an assertion before the CPA can provide the attestation. For example, when
a bank loans money to a company, the loan agreement may require the company to engage a
CPA to provide assurance about the company’s compliance with the financial provisions of the
loan. The company requesting the loan must assert the loan provisions to be attested to before the
CPA can accumulate the evidence needed to issue the attestation report. CPAs can also, for
example, attest to the information in a client’s forecasted financial statements, which are often
used to obtain financing.

1.3 NONASSURANCE SERVICES

CPA firms perform numerous other services that generally fall outside the scope of assurance
services. Three specific examples are:
1. Accounting and bookkeeping services
2. Tax services
3. Management consulting services
Most accounting and bookkeeping services, tax services, and management consulting services
fall outside the scope of assurance services, although there is some common area of overlap
between consulting and assurance services. While the primary purpose of an assurance service is
to improve the quality of information, the primary purpose of a management consulting
engagement is to generate a recommendation to management.
Although the quality of information is often an important criterion in management
consulting, this goal is normally not the primary purpose. For example, a CPA may be engaged
to design and install a new information technology system for a client as a consulting
engagement. The purpose of that engagement is to install the new system, with the goal of
improved information being a by-product of that engagement.
Figure 1-3 reflects the relationship between assurance and non-assurance services.
Audits, reviews, reports on the effectiveness of internal control over financial reporting,
attestation services on information technology, and other attestation services are all examples of
attestation services, which fall under the scope of assurance services. Some assurance services,
such as WebTrust and SysTrust, also meet the criteria of attestation services.

1.4. Types of Audits and Auditors

Audits are often classified in to 3 major types:

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  Audit of Financial Statement
 Compliance Audit
 Operational Audits /Performance Audits/
A. Audit of Financial Statement: Audit of financial statements is actually part of the broader
concept of the attest function. To attest to information mean to provide assurance as to fairness
or dependability. Certified Public Accountants (CPAs) attest to a host of other types of
information including the reasonableness of financial forecasts, the adequacy of internal control
and compliance with laws and regulations. To attest to financial statements is to provide
assurance as to their fairness and dependability. The attest function consists of two phases. The
first is the performance of an audit; the second is the issuance of an audit report. The attest
function leads to credibility to management's representations that are contained in the financial
statements.

The audit of financial statements ordinarily covers the balance sheet and the related statements of
profit and loss and cash flows. Financial audit generally is conducted to ascertain whether the
financial statements present true and fair views of the financial position and working results of
an enterprise or organization. The goals of audit of financial statements are to determine whether
the statements have been prepared in conformity with generally accepted accounting principles.
The aim of an independent financial audit is to ascertain if the financial statements of an
enterprise are reliable and dependable. Financial statements audits are normally performed by
certified public accountants.
The contribution of the independent financial audit is to give credibility to financial statements.
Credibility, in this usage means that the financial statements can be believed. That is, they can be
relied upon by outsiders, such as stockholders, creditors, government and other interested third
parties. The objective of an audit of financial statement is to enable the auditor to express an
opinion whether the financial statements are prepared in all material respects in accordance with
an identified financial reporting framework. The word “audited” when applied to financial
statements means that balance sheet, profit and loss statements and cash flows are accompanied
by an audit report prepared by independent auditors expressing their professional opinion as to
fairness of the enterprise's financial statements. Financial statements prepared by management
and released to outsiders without first being audited by independent auditors leave a credibility
gap. In addition to the audits of financial statements that we have been discussing, you should be
familiar with compliance audits and operational audits.
2. Compliance Audit: The performance of a compliance audit is dependent upon the
existence of verifiable data and of recognized criteria or standard established by an authoritative
body. Such audits seek to determine whether a tax collection is in compliance with tax laws and
regulations.
Compliance audit is defined, as an audit to determine whether verifiable data such as income tax
returns or other financial statements are in conformity with established criteria, for example,
laws and regulations. Society has always been concerned with compliance with laws and
regulations by all types of entities, business, government and nonprofit making organizations.
Legislative public officials and the general public want assurance about compliance. Many
governmental entities and non-profit making organizations that receive financial assistance from
banks are subject to periodic compliance audit. Such audits are designed to determine whether
the financial assistance is spent in accordance with applicable laws and regulations.
In auditing the financial statements of the governmental and non-governmental organizations, the
auditors must often perform tests of compliance with laws and regulations to determine that
violations do not have a direct and material effect on financial statements.

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The auditors may discover violations of provisions of laws, regulations, contracts or grants that
result in which they estimate to be material misstatement to the organization's financial
statements. Such violations are known as material instances of non-compliance. Non-
compliance is the failure to act in accordance with laws or regulations. In these circumstances,
the auditors must consider the effect on their opinion issues on the financial statements. The
resulting misstatement, if left uncorrected, would normally require the auditors to issue a
qualified or adverse opinion. The auditors may also report a description or any indications of
illegal acts that could result in criminal prosecution.
3. Operational and management audit: An operational audit is a systematic independent
appraisal activity within an enterprise for a review of the entire departmental performance as a
service to management. The overall objective of operational auditing is to assist all levels of
management in the effective discharges of responsibilities by furnishing them with objective
analysis, appraisal, recommendations and pertinent comments concerning the activities reviewed.
.
The purpose of an operational audit usually includes the intention to appraise performance of a
particular organizational function or group activities. However, the broad statement must be
expanded to specify precisely the scope of the audit and the nature of the report. The auditors
must determine specifically which policies and procedures are to be appraised and show their
relation to the specific objectives of the enterprise or organization.
Before starting the operational audit, the auditors must obtain a comprehensive knowledge of the
objectives, organizational structure and operating characteristics of the unit to be audited. This
familiarization process might begin with a study of organizational charts statements of the
function and responsibilities assigned are management polices and directives and operating
polices and procedures.
In attempting to meet, managerial needs operational auditors sample the work performance to see
whether it is in accordance with approved procedures. They verify the accuracy and consistency
of the information obtained in operating reports, and they study the format of the reports to
determine whether the information is presented in a meaningful form. The auditor's
responsibility for seeing that the enterprise's assets are safeguarded against fraud is expanded to a
responsibility for providing protection against all kinds of waste. An enterprise having a strong
system of internal control over its cash, inventory, and other personal property will never suffer a
serious loss from fraud or theft.
Now-a-days economic pressures are forcing companies and government enterprises at all levels
to economize, resulting in an increased demand for the information provided by operational
audits. The demand has been so pronounced that operational auditing has become an extension
of the internal auditing function of most large enterprises. Also governmental auditors engage
extensively in evaluating the economy, effectiveness and efficiency of various government
programs.
1.5 TYPES OF AUDITORS
Auditors are often viewed as falling into three main types
 Independent financial auditor /Certified
Public Accountant/
 Internal auditors
 Government auditors
1. Independent financial auditor: Independent financial auditor or certified public accountant is
a person licensed by the state to practice public accounting as a profession based on having
passed the uniform CPA examination and having met certain education and experience.

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Including public accounting profession, all of the recognized professions have many common
characteristics. The most important of these characteristics are a responsibility to serve the
public, of a complex knowledge, standards of admission to the profession and a need for public
confidence. To Certified Public Accountants, public confidence is of special significance.
Credibility is the product of the certified public accountants. Without public confidence in the
attester, the attest function serves no useful purpose. To attest to financial statements means to
provide assurance as to their fairness and dependability. The attest function includes, first, the
independent public accountant, must carry out an examination to provide the objective evidence
that enables the auditors to express an informed opinion on the financial statements. Second, the
attest function is the issuance of the auditor's report, which conveys to users of the financial
statements the auditor opinion as to the fairness and dependability of the financial statements.

Reliable financial information is essential to the very existence of society. Thus, good
accounting and audited financial statement aid society in allocation its resources in the most
efficient manner. The goal is to allocate limited resources to the production of those goods and
services for which demand is greatest. Economic resources tend to be attracted to the industries,
and the organizational entities that are shown by accounting measurements to be capable of using
more resources to the best advantage. Inadequate and inappropriate accounting result on the
other hand, conceal waste and inefficiency and thereby prevent resources from being allocated in
a rational manner. It is the report by the independent auditors that gives credibility to a set of
financial statements and makes acceptable to investors, bankers, government and other users.
2. Internal Auditors: Although most auditing literatures interest is primarily in the audit of
financial statements by Certified Public Accountants, other professional groups carry on large
scale auditing. These well known types of auditors are internal auditors.
The standard definition adapted by the Institute of Internal Auditors of United States of
America, however is that internal auditing is an independent appraisal activity established within
an organization or enterprise to examine and evaluate its activities as a service to the
organization in the effective discharge of their responsibilities by furnishing their analysis,
appraisals, recommendations and counsel. In performing these functions internal auditors can be
considered as a part of the organization's internal control structure. They represent high level
control that functions by measuring and evaluating the effectiveness of other internal control
policies and procedures.
Internal auditors are not merely concerned with the organization's financial controls. Their
work encompasses the entire internal control structure of the organization or enterprise. They
evaluate and test the effectiveness of internal control policies and procedures designed to help
the organization or enterprises to meet all of its objectives.

The internal auditing head often accordingly reports to the general manager or board of directors
or president or another high executive. This strategic placement high in the organizational
structure helps assure the internal auditors will have ready access to all units of the business and
that their recommendations will be given prompt attention by department heads. This reporting
standard provides guidance for the head of internal auditing in managing the internal auditing
functions. The head of internal auditing is responsible for properly managing the departments to
help assured that, the audit work is preformed in accordance with professional standards and
fulfills the general purposes and responsibilities developed by management of the organization
and the resources of the internal auditing department are efficiently and effectively employed.

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A large part of the internal auditors consists of operational audits in addition; they may conduct
numerous compliance audits. The number and kind of investigative activities varies from year to
year. Unlike the certified public accountants who are committed to verify each significant item
in the annual financial statements the internal auditors are not obliged to repeat their audits in
annual basis.
3. Government auditors: A government audit is conducted primarily to ensure that financial
transactions are recorded with proper sanction and authorization. In Ethiopia, the office of
auditors General and office of control has been given the responsibility to conduct the audit of
the central government and the state government. Government auditors examine and make that
 Transactions are correctly recorded and activities conform to the rules and regulations
 Ensure that public funds are not misused
 Examine the efficiency and effectiveness of selected projects or program run by
government

1.6 THE NEED FOR FINANCIAL STATEMENT AUDIT

Auditing service are used by government, business and other not for profit organizations. As
societies become more complex, there is an increasing likelihood that unreliable information will
be provided to decision makers. There are several reasons for this: remoteness of information,
biases and motives of provider, Voluminous of data and existence of complex exchange
transactions.
Financial information users, especially external users may need an independent verification of
the fairness of information stated in financial statements. Because there is a likely hood that
unreliable information may be provided to decision makers for reason of
a. Conflict of interest (biases and motives of provider): The information may be biased in favor
of the provider. Such as misstatement of the information
 In a lending decision, to enhance the chance of obtaining loan
 Misstating revenues to attract investors
b. Voluminous data (improperly recorded information): As the entity become larger, so does the
volume of their exchange transaction. This increases the likely hood that improperly recorded
information will be in the report
c. Complex exchange transaction: exchange transaction between entities have become
increasingly complex and hence more difficult to record properly
d. Remoteness of information: when ever information is obtained from others, the likelihood of
it being intentionally or unintentionally misstated is high. In the modern world, it is virtually
impossible for a decision maker to have much firsthand knowledge about the organization
with which he or she does business. Information provided by others must be relied upon.
Whenever information is obtained from others, the likelihood of it being intentionally or
unintentionally misstated is increased
1.7 GENERALLY ACCEPTED AUDITING STANDARD (GAAS)
There are certain basic principles that underlie every audit. An auditor has to ensure
compliance with these principles in carrying out any audit. Therefore, he has to design his
audit procedures and reporting practices in an auditing situation that he can comply with
these basic principles.

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 Basic principles governing an audit issued by the Institute of Chartered Accountants of USA
that govern an independent audit of financial information are as follows:
A. 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 planning and performance of the
audit and the preparation of the report.

B. STANDARDS OF FIELD WORK.

4. The work is to be adequately planned and assisted, if any, are to be properly
supervised.
5. A sufficient understanding of the internal control is to be obtained to plan the audit
and to determine the nature, timing, and extent of tests to be performed.
6. Sufficient competent evidential matter is to be obtained through inspection,
observation, inquiries, and conformations to afford a reasonable basis for an
opinion regarding the financial statements under audit.

C. STANDARDS OF REPORTING.
7. The report shall state whether the financial statements are presented in accordance
with generally accepted accounting principles.
8. The report shall identify those circumstances in which such principles have been
consistently observed in the current period in relation to the preceding period.
9. Informative disclosures in the financial statements are to be regarded as reasonably
adequate unless otherwise stated in the report.
10. The report shall either contain an expression of opinion regarding the financial
statements, taken as a whole, or an assertion to the effect that an opinion cannot be
expressed; the reasons therefore should be stated. In all cases where an auditor’s
name is associated with financial statements, the report should contain a clear-cut
indication of the character of the auditor’s work, if any, and the degree of
responsibility the auditor is taking.
SUMMARY OF GAAS
GENERAL STANDARDS.
1. Adequate training and proficiency
2. Independence in mental attitude
3. due professional care
STANDARDS OF FIELD WORK
1. Proper planning and supervision
2. Sufficient understanding of internal control
3. Sufficient competent evidence
STANDARDS OF REPORTING
1. Whether statements are prepared in accordance with GAAP
2. Circumstances when GAAP not consistently followed
3. Adequacy of information discloser
4. Expression of opinion on financial statement. General

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