Auditing

Text book: principles of Auditing by Khawaja Amjad Saeed

Chapter 1
Introduction to
Auditing
 Origin of Audit

 The word audit is derived from Latin word

“Audire” which means to hear .In the old days
whenever the proprietors of a concern
suspected a fraud, certain people were
appointed to hear verbal evidence of
transaction of barter and to judge the facts.
They heard the point of views of those who
maintained the accounts.
 Cont….

 With the formation of joint stock companies

and corporations involving large volume of
capital and members under the management
of few individuals compelled and demand the
services of auditors and further the provision
of compulsory audit incase of public limited
companies gives a great importance to this
profession.
Definitions of Audit

 In different times Authors and professional

Accountants have given different definitions
of audit , some of them are as follows:
 “Auditing is the systematic examination and
verification of the accounting records and
other legal records and documents of a
private and public business organizations”.
Given by A. W Holmes
 Cont….

 “Auditing is the process of examining

and evaluating accounting records

intended to show financial conditions
and results of operations in order to
provide basis for opinion regarding the
reliability of the records”. Given by
Silvoso and bauer.
 Cont….

 “Auditing is concerned with the verification of

accounting data, to determine the accuracy and
reliability of accounting statements and reports”.
Given by R.K Mautz
 “ Audit is examination indented to serve as a basis
for an expression of opinion regarding the
fairness, consistency and conformity with
Generally Accepted Accounting Principles, in
preparation of financial statements of the
corporation”.
 Cont…..

 Auditing involves a critical analysis and

examination of the transactions and records
of a concerned with the purpose of forming
an opinion regarding the records and
financial statements of the client.
 An investigation of financial statements
designed to determine their fairness in
relation to Generally accepted accounting
principles.
Book keeping, Auditing, and
Accounting
 Book keeping is the art of recording business
transactions in various books of accounts
maintained in an organization. It is the work
of more or less mechanical in nature, in the
performance of which machinery and electric
devices are being used in advanced countries.
 The work of book keeping is interested to
junior employees know as book keeper or
accounts clerks.
Book keeping process

 The process of book keeping involves the

following stages:
 Entering transaction in various books
 Transferring data from such books to relevant
accounts in ledger
 Casting the ledger accounts and extracting
their balances.
Accounting

 Accounting includes book keeping but it is

principally concerned with the summary analysis
of the record furnished by the book keeping or we
can say that it is compilation of accounts in such a
way that one is in position to know the financial
position and results of operations of a business.
Accounting involves:
 Making adjusting entries necessary at the end of
accounting period.
 Preparation of financial statements
 Cont…

 Interpretation of financial statements

 Designing suitable accounting system
Auditing
Audit is an independent examination of evidence
from which the financial statement of the enterprise
are derived in order to give the readers of those
statements confidence as to the truth and fairness
of the state of affairs which they disclose.
In other words audit is an analytical and critical
examination of the books of accounts, checking and
verification of evidence in supports of entries
appearing in the books of accounts and ascertaining
the authenticity of the financial statements.
 Cont…
 To conclude book keeping, accounting and
auditing are three different stages of same
business activity.
 In a business accounts as has to be maintained
which is book keeping aspect, they have to be
summarized in the form of financial statements
which is accounting aspect and finally for the
satisfaction of the owners or shareholders such
accounts and financial statements has to be
checked to confirm accuracy and fairness of these
which is auditing aspect.
Difference between Accounting and
Auditing
Accounting Auditing
1. It is concerned with recording aspect 1. It is concerned with the examination
of all the financial activities in of the accounting record and
appropriate books of accounts and reporting their accuracy.
compiling financial statements.
2. The accountant prepares the 2. The Auditor submits the report after
financial statements from the books examination of books of accounts
of accounts. and financial statements.
3. No prescribed qualifications are 3. It is mandatory that Auditor of a
legally required to an Accountant. Public Limited company must be a
Chartered Accountant.
4. The job of an Accountant is 4. The Auditor of a Public Limited
generally entrusted to him by company is appointed by
management and he is expected to shareholders of the company.
perform the same.
5. An Accountant is responsible for his 5. The auditor’s rights, duties and
work to the management. liabilities are defined by Law
(Companies Ordinance 1984).
 Auditor

 An individual qualified (at the state level) to

conduct audits. An auditor may be an
internal auditor (an individual whose primary
job function is to audit his or her own
company) or an external auditor (an
individual from outside the company, who
typically is employed by an auditing firm who
handles many different clients).
Qualities Required for an Auditor

1. Professional competence:
 the auditor must be well versed in the
fundamental principles and theories of all
branches of accounting such as general
accounting, cost accounting and management
accounting etc.
 He should posses a sound knowledge of the
techniques of audit, taxation laws of the country
like income tax and sales tax and should be
familiar with the company and mercantile laws.
 Cont…

 He should have thorough training in business

organization, management and finance.
 He should have an understanding of the
general principles of economics and business
statistics.
 Integrity
 The word integrity implies complete
honesty together with strength of mind.
 An auditor must be tactful and honest,
i.e. he must not certify what he does not
believes to be true, and he must take
reasonable care and skill before he
believes what he certifies is true.
 Cont…

 He must posses qualities of withstanding and

resisting the influence(direct or indirect)
exerted by others in the course of the
discharge of his duties.
 He should never compromise his principles
with being rigid in his attitude.
 General Skills

 He should be able to grasp quickly the

technical details of his clients’ business. He
must have the tact of putting intelligent
questions to extract full information.
 He must be prepared to hear arguments and
decide on logical grounds.
 He should have the ability to write his report
in a concise, clear and correct manner.
Objectivity and Independence

 The auditor should be straightforward,

honest and sincere in his approach to his
professional work.
 He must be fair and must not allow prejudice
or bias to override his objectivity and he
should maintain an impartial attitude.
 Confidentiality

 The auditor should maintain confidentiality

of information acquired in the course of his
work and should not disclose any such
information to a third party without specific
authority or unless there is a legal or
professional duty to disclose.
 Object of an Audit

 The objectives of modern auditing are

different from those of classical auditing. The
present day objectives are:
a) Assisting management in maintaining
adequate internal control by pointing out
weak areas.
b) Giving advise to client on matters of
controlling, forecasting, analyzing and
reporting.
 Main object

 The main object of audit is to prove accuracy

and reliability of the accounts and financial
statements prepared by the organization,
and if they are found accurate then auditor
should prepare and issue audit report
accordingly.
 Subsidiary object

 If on the other hand books of accounts and

financial statements are not found correct
then subsidiary objectives may be:
a) To detect error
b) To detect fraud
c) To prevent errors and frauds
 Errors in Accounts

1. Errors of Omission
 These errors occur where the transaction has
been either omitted entirely or partially.
 Such errors do not affect the accuracy of the trial
balance but a searching eye and a critical scrutiny
of the accounts only can uncover such errors.
 For example: scrutiny of salaries account in ledger
may indicate that salaries for only 11 months have
been accounted for and the outstanding amount
for the 12th month has not been accounted for.
 2. Errors of commission

 These consists of incorrect additions, wrong

postings and entries. Some of examples these are:
a) Errors in additions, carry forwards in the books of
original entries or ledger.
b) Errors or incorrect postings like debit amount
posted to credit, wrong amount posted to an
account, an amount posted twice.
c) Error in taking out balances of ledger accounts.
 Cont.….

 These errors will affect the agreement of the

trial balance.
 Checking the arithmetical accuracy of books
of original entries and ledger and posting
from the books of original entries to ledger
would reveal these errors.
 3. Errors of Principles

 These errors arise where a particular

transaction has not been recorded in
accordance with generally accepted
accounting principles. These errors
include:
a) Incorrect allocation: An item of
expense may be debited to an asset
account instead of expense account.
b). Omission of Outstanding assets and liabilities:

For example, prepayment are ignored and the

amount charged of to expense and outstanding
expense in respect of rent, salaries, commission
etc., are ignored and not accounted for.
c). Incorrect valuation of assets:
Current assets are not valued at cost and
market value whichever is lower. Fixed assets
not valued at cost less depreciation.
4. Compensatory Error

 It is an error which is counter-balanced by another

error of same amount in the opposite direction.
For example, an over casting of an account by
$1000 may be counter balanced by under casting
of an other account by same amount.
 Such types of errors will not affect the agreement
of the trial balance.
 Checking of arithmetical accuracy of books of
accounts and postings would detect such errors.
 Locating of Errors
If there is difference in the trial balance and the
auditor is agreed to discover it then he should take
the following steps:
1. Look through folio columns of the books of original
entry to see if any items are not posted to ledger.
2. Re-check the trial balance with the ledger balances.
3. Re-check the balancing of ledger accounts and
carry forward of balances seeing that all opening
balances were properly brought down.
 Cont.…

4. Check all postings from books of original

entries to ledger.
 Frauds in Accounts

1. Misappropriation of cash
misappropriation of cash by dishonest employee is
concealed either by omitting to enter of receipts or
by entering fictitious payments. This can be done in
following ways:
a) Omission of sales and the misappropriation of
cash received by the customers.
b) Theft of unusual receipts of cash like, from sale
of waste, recovery of bad debts written off in the
past.
 Cont.….
c). Cash refund arising out of the invoice overpayment
may not be recorded and amount misappropriated.
d). Recording fictitious purchases and expenses.
e). Cheques for personal purposes may be charged as
business expenses.
f). Vouchers once approved and paid may be used in
support of further reimbursements.
g). Misappropriation of cash drawn in respect of
wages may be done by either inserting dummy names
in the wages sheet or by overcasting the wages sheet.
 2. Misappropriation of Goods

 Goods purchased may be stolen or used for

personal benefits.
 Proper method of keeping accounts in
respect of purchases, sales, consumption,
periodical physical checking of stocks and
comparing them with the records would help
in preventing frauds.
 3. Manipulation of Accounts

 This type of fraud is comparatively difficult to

detect than those discussed earlier, as this is
usually committed by directors and
management with the object of showing
either more profits or less profits than they
actually are. Examples of such fraud are:
 Recording fictitious sales or omission of sales.
 Recording fictitious purchase and omission of
purchases.
 Cont.

 Recording fictitious expenses and omission of

expenses.
 Over-valuation or under-valuation of
inventory.