Chapter Five -Audit Evidence Decisions and Documentation.

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Chapter Six- Audit Report.ppt
Chapter Three-Audit Planning.pptx
Auditing I.ppt
Chapter 2.pptx
Chapter 4 Internal Control.pptx
 Chapter Five
Audit Evidence Decisions and
Documentation
 After completing this chapter , students will be able
to; Understand;
The meaning and nature of audit evidence
Types of audit evidence
Methods of obtaining audit evidence
The relationship of audit risk and audit evidence
Audit work papers and audit evidence
documentation
Types of Audit Work Papers
Organization of audit work papers
Items for examining the clients general records
2
 Introduction
Meaning of Audit evidence
The third standards of field work require an Auditor to
collect sufficient/adequate, competent evidence, which is the
very essence of auditing and forms the basis of issuing audit
opinion.
Evidence is equally important to scientist, medical
practitioners, lawyers and public accountants.
When an auditor accused of negligence his guilt or
innocence is proved on the basis of sufficiency and
competence of evidential matter.

3
 Cont..d
Audit evidence- is the information obtained by the
auditor in arriving at conclusions on which their
reports are based.
During financial statement audits, the auditors gather
and evaluate evidence to form an opinion about
whether the financial statements follows the
appropriate criteria, usually, generally accepted
accounting principles.
Or to provide an adequate basis for their opinion on
the financial statements.
To assure the users of accounting information that
the financial statements are a credible source of
information about the organization.
4
 Cont..d
The users may not accept the auditors opinion on
the truth and fairness of financial statements unless
the auditor has collected sufficient competent
evidence about the material misstatements.

Sufficient competent evidential matter is to be

obtained through inspection, observation,
inquires, and confirmation to afford a
reasonable basis for an opinion regarding the
financial statements under audit.

5
 Cont..d
Audit risk which refers to the possibility that the
auditors may unknowingly fail to appropriately
modify their opinion on financial statements that are
materially misstated, can be greatly reduced by
gathering evidence.
One way to gather additional evidence is to increase
the extent of the audit procedures.
The auditor must gather sufficient evidence to reduce
audit risk to a low level in every audit
The evidence collected by the auditor must be
sufficient and appropriate.

6
 Cont..d
The nature of assertion for which the auditor collects
evidences for an independent financial audit is the following
Existence: the inclusion of an item of asset or liability
in the balance sheet implies an assertion by the preparer
that the asset or the liability exists at the date of the
balance sheet.
Rights and obligations: it is asserted that the assets
shown in the balance sheet are the rights of the
organization and liabilities are the obligations on the
date of the balance sheet
Occurrence: there is an assertion that the transactions
reflected in the financial statements are occurred during
the relevant accounting period and that they pertain to
the organization.
Completeness: this assertion implies that there are no
unrecorded assets, liabilities or transactions.

7
 Cont..d
Valuation: this assertion implies that the assets and
liabilities are included in the balance sheet are at an
appropriate value i.e. as per the normally accepted
bases of valuation.
Measurement: this assertion implies that transactions
have been recorded at proper amounts and that
revenues and expenses have been allocated to the
proper accounting periods
Presentation and disclosure: this assertion implies
that the disclosure, classification and description
of various item in the balance sheet and in the
income statements are in accordance with the
generally accepted accounting standards and
8 relevant statutory requirements
5.1: NATURE OF EVIDENTIAL MATTER
Audit evidence is any information or document that
confirms or rejects a premise (a statement or
hypothesis). The auditors premise that FS presents
fairly the financial position and operating results of
the business.
The third fieldwork standard states that sufficient
competent evidential matter should be obtained to
afford a reasonable basis for an opinion regarding the
financial statements under audit. So the evidence
obtained by the auditor should be
Sufficient
Competent
9
 Cont..d
a) Sufficiency-the term sufficient relates to the quantity of
evidence the auditor should obtain.
To support the auditors opinion is a matter of
professional judgment.
The considerations that should be followed in evaluating the
sufficiency of audit evidence are;
The more competent the evidence matter is, the less
the amount of evidence needed to support the
auditors opinion
The need for the evidential matter is closely related to the
concept of materiality. The more the need for the
materiality the more the evidence is required
Vary from engagement to engagement and it depends
on the factors such as the financial condition of the client,
the line of business, the internal control structure, the
integrity of the management etc.
10
 Cont..d
Competency - refers the quality of the evidence which
depends on its relevance and its validity. For the evidence to be
relevant, it must apply/related/ to the audit objective being tested.
The validity of the evidence refers to its credibility or
believability which depends on the circumstances in
which it is obtained.
The factors that generally affect the validity of the evidential
matter are:
From where the evidence is obtained i.e. whether external or
internal
The effectiveness of the internal control system of the client
company
The collection procedure of the evidence i.e. whether the
evidence is obtained directly or indirectly
The types of evidence i.e. whether they are documents or
written representations or oral evidence
11
 5-2: TYPES OF AUDIT EVIDENCES
The major types of audit evidences gathered by the
auditor during audit are the following:
Physical evidence: Actual physical examination or
observation provides the best evidence of the existence of
certain assets. For example, the existence of plant assets,
inventory, cash etc can be verified by the physical
examination.. It may not be always true. Physical
verification gives evidence of the existence of the asset to
the auditor
Documentary evidence: The worth of the documentary
evidence depends on whether the documents are created
within the company (sales invoices) or it came from
outside the company (vendors invoice). Sometimes the
documents created within the organization are sent
outside for endorsement and processing and these
documents are regarded as very reliable evidence.
12
 Cont..d
The documentary evidence is classified into three categories
and they are
Documents created outside the organization and transmitted
directly to the auditor- the most reliable documentary evidence
consists of documents created by independent parties outside the
organization and transmitted directly to the auditors without passing
through the clients hands. For example, the verification of accounts
receivable
Documents created outside the organization and held by the
organization-many of the externally created documents referred to by
the auditors will be in the possession of organization. For example,
bank statements, vendors invoices and statements, property tax
bills notes receivables etc.
Documents created and held within the organization-
most documents created within the organization represent a
lower quality of evidence because they circulate only within
the company and do not receive critical review by an
outsider. For example, the sales invoices, shipping
notices, purchase orders etc.
13
 Cont..d
Accounting records as evidence: the dependability of ledgers
and journals as evidence is indicated by the extent of internal
control covering their preparation. An auditor will attempt to
verify an amount in the financial statements by tracing it back
through the accounting records.
Evidence from the analytical procedures: analytical
procedures involve evaluations of the financial statements by a
study of relationships among financial and nonfinancial data.
The process of analytical procedures consists of four steps
Develop an expectation of an account balance
Determine the amount of difference from the expectation that can
be accepted without investigation
Compare the account balances with the expected account balance
Investigate the significant deviations from the expected account
balance
For example, comparison of revenue and expense amounts for
the current year to those of the previous years and to the
industries average.

14
 Cont..d
Evidence from computations: to prove the arithmetical
accuracy of the clients records, the auditor make
computations independently as another form of audit
evidence.
Evidence provided by the specialists: since the auditors
may not be experts in all the fields of business of the client,
he may get the services of the experts in performing highly
technical tasks such as valuation of inventory
Oral evidence:, the auditor mayask many questions to
the officers and the employees of the organization.

15
 Cont..d
Evidence from client representation letters: from the
client summarizing the most important oral representations
made during the engagement. These letters are dated as
the last day of the fieldwork and usually signed by the chief
executive officer and chief finance officer. Most of the
representations fall into the following categories;
All accounting records, financial data and minutes of the
directors meetings have been made available to the
auditors
The financial statements are complete and prepared in
conformity with the generally accepted accounting
principles
All items requiring disclosure have been properly
disclosed
16
 EVIDENCE FOR RELATED PARTY TRANSACTIONS

Related parties refer to the client entity and any other

party with which the client may deal where one party has
the ability to influence the other to the extent that one
party to the transaction may not pursue its own separate
interests. Examples of related parties are officers,
directors, principal owners, members of the
immediate families, affiliated companies, subsidiary
companies etc.
A related party transaction is a transaction between the
company and these parties. The primary concern for the
auditor is that significant materials of related party
transactions are adequately disclosed in the clients
financial statement or the related notes. Disclosure of
related party transactions should include the nature of
the relationship, the description of the transactions etc.
17
 Cont..d
Evidences about accounting estimates -The auditor
must be very careful in considering financial statement
accounts that are affected by estimates made by the
management.
For example, the estimates of obsolete/unfashionable
inventory, allowances for loan losses, estimates of
warranty liabilities etc. though the making of estimates are
the responsibility of the management, the auditor should
determine that

All necessary estimates have been developed

The accounting estimates are reasonable and
The accounting estimates are properly accounted for
and disclosed
18
 5.4: Audit procedures / Methods of obtaining audit
evidence/
Auditing procedures-are steps of actions taken in the
process of gathering audit evidence to verify or
accomplish specific task or audit objective. Some of
the common types of audit procedures are as follows:
Physical examination: it means to view physical evidence
of asset. For example, the auditors might physically
examine plant, equipment, or inventory items to obtain
evidence as to their existence or condition.
Confirmation: it is the process of obtaining and evaluating
a response from a debtor, creditor or other parties in reply
to a request for information about a particular item affecting
the financial statements.

19
 Cont..d
Comparison: it is the process of agreeing or
contrasting two different sources of information.
Auditors often use comparison to test information at
various stages of processing within the accounting
system.
Tracing: it is the process of establishing the
completeness of transaction processing by following a
transaction forward through the accounting records i.e.
from the source document to the recorded transaction.
Vouching: it is the process of establishing the
occurrence or valuation of recorded transactions by
following transaction back to supporting document
from a subsequent processing step
20
 Cont..d
Re-performance: is the process of repeating a client
activity. For example the auditors may recalculate the
depreciation or re-perform the bank reconciliation
statement. Re-performance may include Footing is the
process of proving the totals of a vertical column of figures
I. Cross-footing is the proves of proving the totals of
horizontal row
II. Extending is the process of re-computing by
multiplication.
Observation: it is the process of viewing a client activity.
For example, the auditors may observe the application of
internal control procedures such as the clients inventory
taking procedures.
Inspection: it involves a reading or point-by-point review
of a document or record. For example the auditor may
inspect the loan agreement document
21
 Cont..d
Reconciliations: it is used to establish agreement
between two sets of independently maintained by
related records. For example, the cash in bank in the
ledger account is reconciled with the bank statement.
Inquiries: these are the questions directed towards
the appropriate client personnel. The response to the
questions may be written or oral. The term inquiry is
also sometimes used to refer to the technique of
questioning parties outside the organization.
Analytical procedures: they are the evaluations of
financial information made by a study of expected
relationships among financial and nonfinancial data.
For example, the auditor may analyze the financial
ratios of the current year with the ratios of the
22
previous years
 5-5: The relationship of audit risk and audit
evidence
Audit risk-refers to the possibility that the auditors may
unknowingly fail to appropriately modify their opinion
on financial statements that are materially misstated.
Thus, the more sufficient and competent the audit evidence
obtained, the less will be the audit risk. For each financial
statement account, audit risk consists of the possibility that
A material misstatement in an assertion about the account
has occurred, and
The auditors do not detect the misstatement.
The first risk, the risk of occurrence of a material
misstatement, may be separated into two components-
inherent risk and control risk. The risk that auditors will not
detect the misstatement is called detection risk.
23
 Cont..d
Inherent Risk- The possibility of a material
misstatement of an assertion before considering the
clients internal control is referred to as inherent risk.
Factors that affect inherent risk related to either the
nature of the client and its industry or to the nature of the
particular financial statements account.
Inherent risk also varies by the nature of the account.

24
 Cont..d
Inherent risk also varies with the assertion about a
particular account. As an example, valuation of assets is
often a more difficult assertion to audit than is existence of
the assets.
Control risk- The risk that a material misstatement will not
be prevented or detected on a timely basis by the clients
internal control is referred to as control risk. This risk is
entirely based on the effectiveness of the clients internal
control.
To assess control risk, auditors consider the clients
control that affects the reliability of financial reporting. Well
designed controls that operate effectively increase the
reliability of accounting data.
To obtain an understanding of the clients internal control
and to determine whether it is designed and operating
effectively, the auditors use a combination of inquiry,
inspection, observation, and performance of audit
procedures.
25
 Cont..d
Detection risk-The risk that the auditors will fail to
detect the misstatement with their audit procedures is
called detection risk. In other words, detection risk is
the possibility that the auditors procedures will lead
them to conclude that material misstatement does
not exist in an account or assertion when in fact such
misstatement does exist.
Detection risk is restricted by performing substantive
tests. For each account, the scope of the auditors
substantive tests, including their nature, timing and
extent determines the level of detection risk.

26
 5.6. Audit work papers and audit evidence
documentation
Working papers- are the connecting link between
the clients accounting records and the auditors report.
They document all of the work performed by the
auditors and provide the justification for the auditors
report. Information such as audit contact entered to,
audit plans, audit programmers and data gathered ,
description of work performed , documents received,
peoples interviewed, items traced and reconciled ,
events and incidents encountered , evidences
gathered , schedules, experts and photocopies of
financial statements and accounts, references
comments and observations noted --- etc, are
documented in auditors work papers.
27
 5.6.1. Functions of audit work papers
Audit working papers assist auditors in several major ways such as
the following.
Assigning and coordination the audit work
Supervising and reviewing the work of the assistants: The audit
assistants complete audit working papers and the seniors,
supervising the audit work, can review it. If the senior finds any
shortcoming, the senior can write review notes to the assistants
describing additional procedures to be performed or how the
working papers should be revised. The review of working papers by
seniors will help to ensure that the work of audit staff is carefully
reviewed and supervised.

28
 Cont..d
Support for the report: the working papers must contain
adequate evidence and documentation to convince the
auditors engagement. This will help the auditors to arrive
at appropriate opinion on the clients financial statements.
Compliance with the three standards of fieldwork: the
auditors may find themselves liable for the losses
sustained by the users of the financial statements if the
audit was not conducted in accordance with generally
accepted auditing standards. The working papers are the
principal means by which auditors can demonstrate their
compliance with the standards of fieldwork.

29
 Cont..d
Planning and conduction the next audit: The audit
working papers from the previous audit of the
particular client provide valuable information that is
useful in planning and conducting the next audit. The
working papers from the previous audit may be used
as a starting point for designing current year working
papers.
In addition, working papers provides information
useful in rendering additional professional services,
such as preparing income tax returns, making
recommendations for improving internal control, and
providing consulting services

30
 Cont..d
Ownership of the audit work papers-Audit working
papers are the property of the auditors and not of the
client.
Confidential nature of working papers- to conduct a
satisfactory audit, the auditors must be given unrestricted
access to all information about the clients business. Much
of this information is confidential, such as the profit margin
on individual products, tentative plans for business
combinations with other companies, and the salaries of
officers and key employees and other similar issues.
Much of the information gained in confidential way by the
auditors is recorded in their working papers consequently;
the working papers are confidential in nature. Thus, they
must be safeguarded at all times. Safeguarding working
papers usually means keeping them locked in a file
cabinet or an audit case during lunch and after working
hours.
31
 Cont..d
5.6.2. Types of Audit Work Papers
There are numerous types of working papers as the
audit working papers document have a variety of
information gathered by the auditors. The general
categories into which most working papers may be
grouped are ;
Audit Administrative Working Papers: auditing is a
sophisticated activity requiring planning, supervision,
control and coordination. The working papers designed to
aid the auditors in the planning and administration of the
engagement are called as administrative working papers
Working Trial Balance: It is the schedule listing the
balances of the accounts in the general ledger for the
current and previous year and also providing columns for
the auditors proposed adjustments and reclassifications
and for the final amounts that will appear in the financial
statements

32
 Cont..d
Lead Schedules: These are also called as the
grouping sheets or summary schedules and are set
up to combine similar general ledger accounts. The
totals will be appearing on the working trial balance as
a single amount.
Adjusting Journal Entries and Reclassification
Entries: To correct material errors or irregularities
discovered in the financial statements and accounting
records, the auditors draft adjusting journal entries.
Supporting Schedules: Auditors use this term to
describe a listing of the elements or details comprising
the balance in an asset or liability account at a specific
date.
33
 Cont..d`
Analysis of Ledger Accounts: An analysis of a ledger account
is another common type of audit working paper. The purpose of
an analysis is to show on one paper all changes in an asset,
liability, equity, revenue, or expense account during the period
covered by the audit.
Reconciliations: is the relationship between amounts obtained
from different sources. Reconciliations provide evidence as to
the accuracy of one or both of the amounts and are important to
the audit of many accounts including cash, accounts receivable,
and inventories.
Computational working papers: The auditors approach to
verifying certain types of accounts and other figures is to make an
independent computation and compare their results with the
amounts shown by the clients record.
Corroborating/Supporting Documents: Auditing is not limited to
the examination of financial records, and working papers are not
confined to schedules and analyses. During the course of an
audit, the auditor gathers much purely expository material to
substantiate their report.
34
 5.6.3. Organization of Audit Work Papers
The auditors usually maintain two files of working
papers for each client:
Current files for every completed audit and
Permanent file of relatively unchanging data.
The Current files: - The auditors report for a particular year
is supported by the working papers contained in the current
files. Many CPA firms have found it useful to organize the
current files around the arrangement of the accounts in the
clients financial statement.
The Permanent File: - The permanent file serves three
purposes
To refresh the auditors memories on items applicable
over a period of many years
To provide for new staff members a quick summery of the
policies and organization of the client and
To preserve working papers on items that show relatively
few or no changes, thus eliminating the necessity for their
35 preparation year after year.
 5.6.4 Examination of general records-
In the different stages of audit; the independent
auditor must become familiar with the many
aspects of the business of the client. The internal
activities of the client are not in itself sufficient.
If the information is to be interpreted and evaluated
in a proper perspective, the auditor must also
understand the business environment in which the
client operates. The auditors can gain considerable
information about both the clients business
environment and internal operations by examining
the clients general records. The term general
records is used to include the following categories:
36
 Cont..d
Non-financial records
Articles of incorporation and by-laws
Partnership contracts
Minutes of directors and share holders meetings,
Contracts with suppliers and customers.
Contracts with employees
Government regulations effecting the business
Correspondence files
Financial Records
Income Tax returns of previous years
Financial statements and annual reports of previous years
Registration statements and periodic reports, files with government
agencies
Accounting records
Ledgers
37
Journals
 Cont..d
Articles of Incorporations and Bylaws: - It is a basic document
filed with the government to evidence the legal existence of
the organization. By laws are the internal administrative
structures of the organizations. They include the
organizational structures, rules and procedures adopted by the
corporate shareholders. Copies of both the articles of
incorporations and by laws are retained in the auditors
permanent files for convenient reference during the repeated
audit engagements.
Partnership Contract: - The partnership contract represents
an agreement among the partners on the rules to be
followed in the operations of a partnership organization.
The auditor should examine the partnership contract in the same
manner as the articles of incorporation and by laws of corporate
clients while auditing a partnership firms.
Minutes Book: - A minutes book is an official record of the
actions taken at the meetings. It will contain certain
authorizations, more important transactions and contractual
arrangements etc.
38
 Cont..d
Contracts held or issued by the client: - During audit
engagements, the auditor should obtain the copies of all major
contracts, to which the client is a party. The terms of existing
contracts are often the material factors in arriving at certain
decisions while expressing the opinion..
Laws and Regulations: - The independent auditor must be
familiar with the laws and regulations that might affect the clients
financial statements. The audit must be designed to provide
reasonable assurance of detecting illegal acts having a material
direct effect on the financial statements. While a audit does not
generally provide a basis for detecting violations of laws and
regulations which have an indirect effect on the financial
statements, the auditor must be aware of the possibilities that such
violations have occurred.
39
 Cont..d
Correspondence Files: - The general correspondence
files of the client may contain more information which will
be important to the independent auditors.
Correspondence may be generally accepted as authentic
one. But if reason for doubt exists the auditor may wish to
confirm the contents of correspondence with the
responsible persons directly.
Financial Statements of Previous Years: - The auditors
can gain general background knowledge of the financial
history and problems of the business by studying the
financial statements and annual reports of the previous
years. If the independent auditors have submitted the
audit reports in previous years, these documents may be
useful in drawing attentions in matters requiring special
considerations.
Tax returns of previous years: - A review of tax returns
of previous years will aid the auditors in planning the tax
services if required by the terms of engagement..
40
 Cont..d
Registration Certificates and Periodic Reports: - The registration
statement and periodic reports filed with the government agencies will
contain valuable information necessary for the auditors. It may
contain information about the clients capital structure, summary of the
earnings of the previous years, identity of the affiliated companies,
description of the business of the property of the client, pending legal
proceedings, names of directors and executive officers of the client
and their remuneration, principal shareholder etc.

Review and testing of Accounting Records: - A review of these

records will help the auditor to understand the clients accounting
system thoroughly and to assess the quality of accounting records, the
accounting procedures, the control procedures, in effect etc. If the
clients accounting records and procedures are well designed and
efficiently maintained it is reasonable to devote less audit time to verify
the accuracy of the records than would be required. The extent to
which the auditors test the accounting records will depend on two
factors i.e., the general conditions of the records and the frequency
and related importance of any misstatements discovered during the
actual testing.

41
 Cont..d
General Ledger: - Auditors should test the general
ledger by performing tests to determine whether
1. Account balances are mathematically correct.
2. Entries in the ledger were posted from journal
entries and
3. Journal entries were properly posted to the
appropriate ledger accounts.
General Journal: - Entries in the general journal are
those for which special journals have not been provided
accordingly a variety of infrequently occurring
transactions is normally included. The auditor should
Check the total column of the journal
Vouch selected entries to the original documents
Scan the journals for unusual entries
Determine the entries that have been with proper approval of
concerned officer.
42
Chapter Six
Audit Report
 After the end of this session, students
will be able to identify;

The nature of audit report and its

importance
The basic elements of audit report
Types of audit reports and its
distinguishing characteristics

2
 Introduction
Definition /Nature of Audit Report
An audit report is an appraisal of a small businesss
complete financial status, Completed by an independent
accounting professional. This document covers a
companys assets and liabilities, and presents the auditors
educated assessment of the firms financial position and
future. Or
An auditors report is the independent examination of, and
expression of opinion on the financial statements of the
company by appointed auditors in pursuance of that
appointment and incompliance with any statutory
obligations
The responsibility for the preparation of the financial
statements and the presentation of the information included
3 therein rests with management of the company.
 Cont..d
The auditors responsibility under the companies Act is to
make a report to the members of the company on the
books of accounts and financial statements besides
others necessary and relevant documents examined by
him/her/them.
The auditors report is, therefore, the means by which the
auditors formally communicates the results of his /her/audit
to the members of the company as well as to the
readers of financial statements, such as creditors,
financial institutions, and all others who have a stake in
the company or wish to acquire a stake or transact with
the company. The messages that are communicated
through the audit report are based on various conclusions
reached by the auditors in the course of his/her
examination.
4
 Cont..d
Is an auditor is a guarantor or an insurer ?...... No
The auditors report does not guarantee the truth or
otherwise of the matter reported upon; it is
expression of auditors opinion on the financial
statements. That is, an auditors opinion on the
financial statements
An auditors /auditors/ can not ascertain and state or
certify the exact figure of various assets and liabilities.
All they can do is to report whether or not, in his
opinion, the financial statements are true and fair.
Different auditors may form different opinion based on
their exercises of judgment on the same set of financial
accounts.
5
 Purpose and Form of Audit Report
6.1.1 Purpose of Audit Report
In the case of joint stock Company, the
auditors report is very important as the shareholder
of the company do not possess full facts about the
day to day working. They appointed an auditor to
thoroughly checks the accounts of the company
and submit a report to them about; the financial
affairs of the company.
Moreover, the auditors report also provides information
about state of a given companys affairs to other interested
parties such as creditors, investors, and other financial and
governments institutionetc
6
The main significance of audit report;
It substantiates that the financial information of the
company reflects a true and fair picture of the state of
affair of clients business.
It summarizes the result of the audit work carried out by
the auditors
A report from acquainting the shareholders with material
facts about the affairs of companys business, it offers an
opportunity to the readers of financial statements such as
creditors, bankers, financial institutions, and potential
investors and others to get reliable insight into the financial
position of the company as reflected by its profit and loss
accounts and the balances sheet.
Auditors report is the indicator of credibility of financial
statements.
7
 6.1.2 Form of audit report
According to the guidelines, the basic elements of
the auditors report are as follows:
Title: An appropriate title as Auditors Report, helps
the users / readers / to identify the report and to
distinguish it from reports issued by others.
Address: The report should be appropriately
addressed. For example, in the case of a statutory
audit of a company, the report is addressed to the
shareholders.
Identification of financial statements: The financial
statements can be identified by including the name of
the entity and the date period covered by the financial
statements.
8
 Elements of audit report cont..d

Introductory paragraph The first paragraph of the

auditors report is reflected to as the introductory
paragraph. It clearly states:
The financial statements that have been audited
The financial statements are the responsibility of
managements
The auditors responsibility/CPA firm/ is to express
an opinion on them.
Scope paragraph- Is the second paragraph of
auditors report which describes the nature of an
audit, that is, the standards being followed and
procedures applied.
9
 Elements of audit report cont..d
Reference to auditing standards or practices: Such references
in the report assure the reader that the audit has been carried out in
accordance with established standards or practices.
Opinion on the financial statements: The report should clearly
set forth the auditors opinion on the entitys financial positions and
operational results e.g. the financial statements give a true and fair
view.
- auditor has reached in his professional opinion
Signature: The report should be signed in the name of the audit
firm or the personnel name of the firm sings on behalf of the firm
in case of statutory audit of companies.
Auditors or Audit firms Address: The report should also
mention the specific location in the city where the auditor(s), or
audit firm maintain his offices.
10

 6.2: Types of auditors reports (opinions)
Expressing an independent and expert opinion on the fairness of
financial statements is the most important and valuable service
rendered by auditors. Thus, the auditors reports may be classified
as follows;
A. Unqualified ( clean ) report
B. Qualified report / negative report/
C. Adverse report
D. Disclaimer of opinion ( no-opinion)

11
 Cont..d
A) Unqualified (clean) report
-Often called a clean opinion
-is an audit report that is issued when an auditor
determines that each of the financial records provided
by the small business is free of any
misrepresentations. In addition, an unqualified opinion
indicates that the financial records have been
maintained in accordance with Generally Accepted
Accounting Principles (GAAP). This is the best type of
report a business can receive.
-Typically, an unqualified report consists of a title that
includes the word independent. This is done to
illustrate that it was prepared by an unbiased third
12party.
 Cont..d
The title is followed by the main body. Made up of three
paragraphs, the main body highlights the responsibilities of
the auditor, the purpose of the audit and the auditors findings.
The auditor signs and dates the document, including his
address.
An auditors report with an unqualified opinion may be
issued only when the following two conditions have been
meet.
The financial statements are presented in conformity with
generally accepted accounting principles, including disclosure.

The audit was performed in accordance with generally accepted

auditing standards, with no significant scope limitations
preventing the auditors from gathering the evidence necessary
to support their opinion.
13
 Cont..d
The unqualified auditors report could take either of the
following two forms.
(A).An unqualified opinion- standards report- The
standard report express a clean opinion and may be
issued only when the two conditions listed in the preceding
sections have been met and when no conditions requiring
explanatory language exists.
(example page-3 of this chapter)
(B) An unqualified opinion with explanatory language-
under certain circumstances, auditors add explanatory
languages to their report, even when issuing an
unqualified opinion. Adding the additions languages is not
regarded as a qualified; rather, the language merely draws
attention to a significant situation.
14
 Cont..d
Auditors may add explanatory languages to a
report to:
I. Indicate that a part of the audit was performed by other
auditors- In some audits the principal auditor of a company
rely upon another auditors or audit firms to perform a
portion of the audit work e.g. audit of consolidated entities
financial information.
In such cases, the principal auditors issues audit
report in two basic alternatives. These are:
(a)Make no references to the other auditors-if the
principal auditors make no reference in their report
to the portion of the engagements performed by
other auditors, the principal auditors assume full
15 responsibilities for the other auditors work.
 Cont..d
(b) Make reference to the other auditors- making reference to the
work done by other auditors divides the responsibility for the engagements
among the participating auditors firm or audit firm. This type of report is
called a shared responsibility opinion, even though it is signed only
by the principal auditors.

16
 Cont..d
ii) Point out an uncertainty about the companys ability
to continue as a going concern. The Auditors
consideration of an Entitys Ability to continue as a going
concern requires that auditors evaluate whether there is
substantial doubt about the clients ability to continue
as a going concern for a reasonable period of time,
which is defined as not exceed one year beyond the date
of the financial statements being audited.
(iii)Describe an inconsistency in the application of
accounting principles.- when the auditors believe that the
new principles is generally accepted, the accounting proper,
and the change is justified, the audit report is modified to
highlight the lack of consistent application of acceptable
accounting principles, but the opinion remains unqualified.
17
 Cont..d
(iv) Emphasize a matter- Auditors also may issue an unqualified
opinion that departs from the wording of the standards report in
order to emphasize a matter regarding the financial statement.
V) Describe a justified departure from officially recognized
accounting principles- some times, clients may believe that it is
appropriate for the financial statements to depart from officially
recognized accounting principles in order to achieve the more
important objectives of a fair presentation. When the auditors
agree, they may still issue an unqualified report, but they must
disclose the departure in explanatory paragraph, either before or
after the opinion paragraph.

18
 B) Qualified opinions
a qualified opinion expresses the auditors reservations or
uncertainty about fair presentation in some areas of the
financial statements. The opinion states that except for the effects
of some deficiency in the financial statements, or some limitations
in the scope of the auditors examination, the financial statements
are presented fairly.
All qualified reports include a separate explanatory paragraph
before the opinion paragraph disclosing the reasons for the
qualification. Opinion paragraph of a qualified report includes the
appropriate qualifying language and a reference to the explanatory
paragraph.

19
 Cont..d
Qualified audit reports should be carefully worded to auditors are
qualifying their opinion.
It should not include precisely worded qualifying languages that
include the phrase such as except for or with the exception of.
The materiality of the exception governs the use of the qualified
opinion.

When the report is qualified, the introductory and scope paragraph

of the standard report are unaffected. The modification involves
adding an explanatory paragraph following the scope paragraphs and
qualifying the opinion paragraph

20
 Cont..d
Auditors may issue qualified audit opinion when
I. There is a departure from generally accepted
accounting principles by client and auditors do not agree
with the accounting principles used in preparing financial
statements. When the departure is immaterial, on unqualified
opinion may be issued. But, when it is material but not material
enough to make the financial statements misleading, a qualified
opinion is appropriate.
The term material is used to describe problems sufficient to
require qualification of auditors report but which do not
overshadow the fairness of the statements in this case.

21
 Cont..d
II) Scope limitations- limitation on the scope of an audit
arise when the auditors are un able to perform an essential
audit procedures. Limitation may be imposed either by
circumstances surrounding the audit (for example, the
auditors were engaged too late in the year to observe the
clients beginning inventory or by the client ( for example , the
client refuses to allow the auditor to send confirmation to
customers.
III) When the account do not disclose a true and fair
view of the companies affair, and when books of
accounts have not been kept in accordance with the law and
profit and loss accounts are not in agreements with the books
22
of account and other related issues.
 C) Adverse Opinions-
An adverse opinion is the opposite of an unqualified opinion; it is an
opinion that is issued when;
I. The financial statements do not present fairly the financial position,
results of operation, and cash flows of the client in conformity with
generally accepted accounting principles.
II. When the deficiencies (departure) in the financial statements are so
significant, that the financial statements taken as a whole are
misleading.
When the auditors express an adverse opinion, they must have set
forth in an explanatory paragraph, all significant evidences to support
this unfavorable opinion i.e. they should disclose in a separate
paragraph of their report the reasons for the adverse opinion and the
principal effect on the financial statements, if the effects can be
23
determined.
 Cont..d
An audit report that express an adverse opinion generally includes
standard introductory and scope paragraphs, one or more
explanatory paragraphs preceding the opinion paragraph and
describing the reasons for the adverse opinion, and an opinion
paragraphs.
Because the reasons for an adverse opinion are usually lengthy and
complex, we illustrate only, the opinion paragraph below.

Adverse opinions are rare because most clients follow the

recommendation of the independent auditors with respect to fair
presentation of financial statements

24
 D) Disclaimer of opinion
A disclaimer of opinion means giving no opinion as
to the status of the financial statements under audit.
Auditors issue a disclaimer whenever:
I. Auditors are un able to form an opinion or have not
formed an opinion as to the fairness of presentation
of the financial statements due to significant
scope limitations either by substantial
circumstances and/ or by client and this limitations of
scope precludes the auditors compliance with
generally accepted auditing standards and
II. When a material uncertainty affects the financial
statements.
E.g. The probable outcome of a very significant lawsuit
25 against the client
 Cont..d
Disclaimers are not alternatives to adverse opinion.
A disclaimer can only be issued when the auditors do
not have sufficient information to form an opinion on
the financial statements.
If the auditors have already formed an opinion that
the financial statements are not a fair presentation,
the disclaimer can not be used as a way to avoid
expressing an adverse opinion.

26
 Contd
Independent auditors report the phrase Financial
statements present fairly, in all material respects may
be used since many of items in the financial statements
cannot be measured exactly, the auditors cannot say
that the statements present exactly or correctly the
financial position or operating results.
The meaning of present fairly independent
auditors report is to state the fairly stated financial
statements are;
I. Prepared in accordance with accounting principles
that have general acceptance and are appropriate in
the circumstance
II. Information of matters that may affect their use,
27 understanding and interpretation
 Cont..d
I. Presented in a manner that is classified and
summarized in a reasonable manner, neither too
detailed nor too condensed.
II. Prepared to reflect transactions and events within a
range of reasonable limits.

28
 The End
29
Under this chapter;
Students will be able to identify ;
The importance and objectives of the audit
planning
The main elements in planning the audit
How to perform preliminary analytical
procedures
The concept of materiality and audit
sampling
The role of audit working paper
Introduction
3.1 Audit Planning
As per Auditing and Assurance Standard
(AAS) 1, Basic Principles Governing an
Audit, Audit Planning is one of the basic
principles. Accordingly, it states The auditor
should plan his or her work to enable him
or her to conduct an effective audit in an
efficient and timely manner. Plans should
be based on knowledge of the clients
business.
 Cont..d
The plan should be made to cover, among
other things:
Acquiring knowledge of the clients
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.
 Cont..d
AAS-8 further expound this principle. According
to it, planning should be continuous throughout
the engagement and involves:
Developing an overall plan for the expected scope
and conduct of the audit;
Developing an audit programme showing the
nature, timing and extent of audit procedures.
Changes in conditions or unexpected results of
audit procedures may cause revisions of the
overall plan of and the audit programme.
The reasons for significant changes may be
documented.
 Cont..d
Objectives of Planning
The first standard of fieldwork states:
The work is to be adequately planned,
and assistants, if any, are to be properly
supervised. The concept of adequate
planning includes investigating a
prospective client before deciding whether
to accept the engagement, obtaining an
understanding of the clients business
operations, and developing an overall
strategy to organize, coordinate, and
schedule the activities of the audit staff.
 Cont..d
Adequate audit planning helps to:
Enable the auditors to obtain sufficient competent
evidence for the circumstances
keep audit costs reasonable
Avoided misunderstandings with the client.
Ensure that appropriate attention is devoted
to important areas of the audit.
Ensure that potential problems are promptly
identified;
Ensure that the work is completed
expeditiously/on time
Utilize the assistants properly; and
Co-ordinate the work done by other auditors
and experts
 Cont..d
In planning his/her audit, the auditor will
consider factors such as complexity of the
audit, the environment in which the entity
operates , previous experience with the client and
knowledge of the clients business.
The auditor may wish to discuss elements of his
overall plan and certain audit procedures with the
client to improve the efficiency of the audit and
to coordinate audit procedures with work of
the clients personnel.
The overall audit plan and the audit programme,
however, remain the auditors responsibility
 Cont..d
In planning the audit, the auditor needs
to consider the following ;
The terms of the engagement and the expected
date of the report.
The nature of the clients business, include
applicable statutory and contractual
requirements.
The experience gained during previous audit
engagements.
The accounting policies and degree of
complexity of the accounting system.
Materiality and the components of audit risk.
 Cont..d
Any involvement of other auditor.
Any involvement of internal auditors and
persons having special expertise.
The intended reliance on internal control.
The level of experience and the number of
audit staff for the engagement.
The timing and effectiveness of performing
of the audit procedure.
 Cont..d
Much of early planning on audit deals with
obtaining information to help auditor assess
these risks.
Acceptable audit risk-is a measure of how
willing the auditor is to accept that the financial
statements may be materially misstated after
the audit is completed and an unqualified
opinion has been issued. When the auditor
decides on a lower acceptable audit risk, it
means that the auditor wants to be more certain
that the financial statements are not materially
misstated. Zero risk would be certainty, and a
100 percent risk would be complete
uncertainness.
 Cont..d
Inherent risk-is a measure of the auditors
assessment of the likelihood that there are
material misstatements in an account balance
before considering the effectiveness of internal
control.
For example, the auditor concludes that there
is a high likelihood of material misstatements in
an account such as accounts receivable, the
auditor would conclude that inherent risk for
accounts receivable is high.
When the auditor concludes that there is a
high inherent risk for an account or a class of
transactions.
 Cont..d
When the auditor decides that a lower
acceptable audit risk on an audit is appropriate,
there are three potential actions, where all three,
two or just one can be done, depending on the
auditors judgments.
1. More evidence is required to increase audit
assurance that there are no material
misstatements; it is difficult to implement
increased evidence accumulation because
acceptable audit risk applies to the entire audit.
It is expensive and often impractical to
increase evidence in every part of an audit
 Cont..d
2. The engagement may require more experienced
staff. Audit firms should staff all engagements with
qualified staff, but for low acceptable audit risk
clients special care is appropriate in staffing.
3. The engagement will be reviewed more carefully
than usual. Audit firm need to be sure that the
working papers that document the auditors
planning, evidence accumulation and conclusion,
and other matters in the audit are adequately
reviewed. When acceptable audit risk is low, there is
often more extensive review, including a review by
personnel who were not assigned to the
engagement
 Cont..d
3.2 Planning Procedures
To conduct the audit the auditor needs to follow the
process of audit procedure:
a) Client acceptance
The auditors should investigate the history of the
prospective client, including such matters as the identified
and reputations of the directors, officers, and major
shareholders, its financial statements and audit report.
Sources of information
Communication with predecessor auditors.
Make enquiries of other third parties (e.g. banker.).
Consult the clients legal counsel.
The client's Annual Reports to Shareholders.
Minutes of Meetings of Shareholders, Board of Directors
and important Committees.
 Cont..d
b) Obtaining the engagement
After the auditors have collected the necessary
information on the potential client, they will be in a
position to assess the various risk involved with the
audit and determine whether to attempt to obtain the
engagement. Often they will be asked to submit a
proposal which will include information on the nature
of services that the firm will offer, the qualification of
the firms personnel, and other information to convince
the prospective client to select the firm.

Fee arrangement: when the business engages the

services of independent public accountant, it will
usually ask for an estimate of the cost of the audit.
 Cont..d
Engagement letter: The preliminary
understandings with the client should be
summarized by the auditors in an engagement
letter, making clear the nature of the engagement,
any limitations on the scope of the audit, work to
be performed by the clients staff, schedule dates
for performance and completion of examination,
and the basis for computing the auditors fee.
 Cont..d
(c) Obtaining an understanding of the clients -
business.
After the engagement is accepted, the auditors
must obtain a detailed understanding of such
factors as the clients financial position and
operating results, organization structure, product
lines, and methods of production and
distribution. This will help auditors to evaluate
the appropriateness of the accounting principles
in use or the reasonableness of the many
estimates and assumptions embodied in the
clients financial statements.
 Cont..d
d) Developing an overall audit strategy
After obtaining knowledge of the clients
business, the auditor should formulate an
overall audit strategy for the upcoming
engagement. The best audit strategy is the
approach that results in the most efficient
audit. In planning an audit, the auditors
must consider carefully the appropriate
levels of materiality and audit risk.
 Cont..d
Materiality: In planning the audit, auditors
should design their audit procedures to avoid
wasting time searching for immaterial
misstatements that cannot affect their report.
Audit risk: The term audit risk refers to the
possibility that the auditors may unknowingly
fail to appropriately modify their opinion on
financial statements that are materially
misstated.
In developing an audit plan, the auditors must
consider factors that affect audit risk.
 Cont..d
(e) Audit Plans
The planning process is documented in the
audit working papers through the
presentation of audit plans, audit programs,
and time budget. An audit plan is an
overview of the engagement, outlining the
nature and characteristics of the clients
business operations and the overall audit
strategy.
 Cont..d
A typical audit plan includes the following:
Description of the clients company-its
structure, nature of business, & organization.
Objectives of the audit.
Nature and of extent of other services.
Timing and scheduling of audit work.
Work to be done by the clients staff.
Staffing requirement during the engagement.
Target dates for completing major segments of
the engagement.
Preliminary judgment about materiality and risk
levels for the engagement
 Cont..d
(f) Designing audit programs
An audit program is a detailed list of audit
procedures to be performed in the course of
the examination. An audit program is
designed to accomplish certain objectives
with respect to each major account in the
financial statements. These objectives
follow directly from the assertions that are
contained in the clients financial statements.
 Cont..d
Discussion with client:
According to AAS - 8, during the course of planning
the audit, discussions with the client might include the
wing subjects -
Changes in Management, Organizational Structure,
and activities of the client.
Current Government Legislation, Rules, Regulations
and Directives affecting the client.
Current Business Developments affecting the client.
Current or impending Financial Difficulties or
Accounting Problems.
Existence of Interested Parties and transactions with
them.
 Cont..d
3.3 AUDIT WORKING PAPERS
Working papers are records kept by the
auditor of the procedures applied, the test
performed, the information obtained, and the
pertinent conclusions reached in the audit. For
example, when samples are takes for audit
tests, the items drawn must be recorded and
computations must be made.
Working papers provide:
The principal support for the auditors report.
Is a means for coordinating and supervising
the audit, and.
Evidence that the audit was made in
accordance with GAAS.
 Cont..d
Working papers normally include the audit
plan and programs, documentation of the
auditors understanding of the internal control
structure, the assessed level of control risk,
account analyses explaining the composition
of account balances, reconciliation of related
records, letters of confirmation and
representation, recommended journal entries
if necessary to correct the accounts, and trial
balances and other schedules that summarize
the contents of other working papers.
 Cont..d
The audit working papers constitute
the link between the auditors report
and the clients records.
 Cont..d
IMPORTANCE OF AUDIT WORKING PAPERS
It provides guidance to the audit staff regard to the
manner of checking the schedules.
The auditor is able to fix responsibility on the staff
member who signs each schedule checked by him.
It acts as an evidence in the court of law when a charge of
negligence is brought against the auditor.
It acts as the process of planning for the auditor so
that he can estimate the time that may be required for
checking the schedules.
The auditor should adopt reasonable procedures for
custody and confidentiality of his working papers and
should retained them for a period of time sufficient to
meet the needs of his practice and satisfy any pertinent
legal or professional requirements of record retention.
 Cont..d
Factor Determining Form and Contents Of Audit
Working Papers:
Working papers should record the audit plan,
nature, timing and extent of auditing procedures
performed, and the conclusions drawn from the
evidence obtained. The form and content of working
papers are affected by matters such as:
Nature of the engagement.
Form of the auditors report.
Nature and complexity of the clients business.
Nature and condition of the clients records and
degree of reliance on internal controls.
Need in particular circumstances for direction,
supervision and review of work performed by
assistants
 The two types of Audit Files
Permanent Audit File: A permanent audit file normally
includes:
Information concerning the legal and organizational
structure of the entity. In case of a company, this
includes the memorandum and Article of association.
In the case of a statutory corporation, this includes the
act and regulations under which the corporation
functions.
Extracts or copies of important legal documents,
agreements and minute relevant to the audit.
A record of the study and the evaluation of the
internal controls related to the accounting system. This
might be in the form of narrative descriptions,
questionnaires or flow charts, or some combination
thereof.
 Cont..d
Current Audit File: The current file normally
includes
Correspondence relating to acceptance of annual
reappointment.
Extracts of important matters in the minutes of
board meetings and general meetings as relevant
to audit.
Evidence of the planning of the audit and audit
programme.
Analysis of transactions and balances.
A record of the nature, timing and extent of
auditing procedures performed, and the results of
such procedures etc.
 Cont..d
Ownership and Custody Of Working
Paper
Working papers are the property of the
auditor. The auditor may, at his discretion,
make portions of or extracts from his
working papers available to his client. Audit
working papers are the property of the
auditor and he is entitled to retain it.
 Cont..d
MATERIALITY:
Information is material if its misstatement
(i.e., omission or erroneous Statement) could
influence the economic decisions of users
taken on the basis of the financial
information.
Materiality depends on the size and Nature of
the item, judged in the particular
circumstances of its misstatement.
 Cont..d
The concept of materiality recognizes that some
matters, either individually or in the aggregate,
are relatively important for true and fair
presentation of financial information in
conformity at both the overall financial
information level and in relation to individual
account balances and classes of transactions.
 Cont..d
Although the auditor ordinary establishes an
acceptable materiality level to detect quantitatively
material misstatements, both the amount (quantity)
and nature (quality) of misstatements need to
be considered.
An example of a qualitative misstatement would
be the inadequate or improper description of an
accounting policy when it is likely that a user of the
financial statements would be missed by the
description.

The auditor needs to consider the possibility of

misstatements of relatively small amounts than,
cumulatively, could have a material effect on the
financial information.
 Cont..d
Materiality should be considered by the
auditor when-
(a)Determining the nature, timing and extent
of audit procedures;
(b) Evaluating the effect of misstatement.
 Cont..d
Audit Sampling
Definition: Application of audit procedures to less than 100 % of the
items within an account balance or class of transactions to obtain and
evaluate audit evidence about some characteristic of the items
selected in order to form or assist in forming a conclusion concerning
the population.
Sampling risk
Because the auditor dose not examine all the items in the
population when applying audit sampling, there is a risk that the
conclusion that he draws will be different from that which he
would have drawn had he examined the entire population. This
is sampling risk.
The following are the basic factors affecting sample size:
Population size.
Standard deviation.
Materiality.
Reliability.
 Cont..d
Statistical and non-statistical sampling
Statistical sampling involves the use of mathematical procedures,
such as probability theory to draw conclusions reached about the
population.
Non-statistical sampling techniques rely on the auditors judgment to
draw conclusions.
2. Constructing sampling.
The steps involved in sampling can be summarized as follows:
Sample design: - when designing an audit sample, the auditor
should consider the specific audit objectives, the population from
which the auditor wishes to sample, and the sample size.
Selection of the sample: - the auditor should select sample items
in such a way that the sample can be expected to be representative
of the population.
Evaluation of the sample: - having carried out, on each sample
item; those audit procedures that are appropriate to the particular
audit objective, the auditor should:
Analyze any errors detected in the sample.
Project the errors found in the sample to the population, and
Reassess the sampling risk.
 Department of Accounting and Finance

Auditing Principles and Practice I

Compiled By: Wondimu S.(M.Com(Finance)

1 10/5/2017
 Chapter One
An overview of Auditing
In this unit;
Definition and Nature of Auditing
Accounting Vs. Auditing
Type of Audit and Auditors
Economics of Auditing

2 10/5/2017
 Introduction
Origin and Historical development of Auditing
The term Audit is derived from the Latin word
Audere which means to hear. In the olden days,
whenever the proprietors of a business concern
suspected a fraud, certain people were appointed to
hear verbal explanations given by the persons
responsible for maintaining the books of accounts and
to judge the facts. Such persons were known as
Auditors. Thus, the literal meaning of audit is to
hear and the auditor is the person who hears the
explanations from the persons accountable for
keeping accounts.
3 10/5/2017
 Historical Devt cont..d
Scope of audit was quite limited as the auditors
during those days were interested in ascertaining
whether the persons responsible for keeping
accounts had properly accounted for all cash
receipts and payments to his principal and in
locating errors and fraudulent transactions, if any.

In simple words, the aim of audit was to

know whether cash had been embezzled and
if so, who embezzled it and what amount
was involved.

4 10/5/2017
 Cont..d
Thus, it was merely a cash audit. But, the scope of
modern audit can not be confined to cash
verifications as the principal object of modern audit
is to report on financial position of the undertaking
as depicted by its financial statements, i.e.
Balance sheet and Profit and Loss account, and
other financial and non-financial information that
are related to different aspects of organizations
economic activities.
Detection of errors and fraud is an incidental
object of modern audit

5 10/5/2017
 Historical Devt cont..d
As far as the historical development of auditing is
concerned, although the objectives and concepts
that guide present day audit were almost unknown
until the early years of the 20th century, audits of
one type or another have been performed
throughout the recorded history of commerce and
government finance.
From medieval times on through the time of
industrial revolution, audits were performed to
determine whether persons in position of official
responsibility in government and commerce were
acting and reporting in an honest manner.
6 10/5/2017
 Cont..d
During the industrial revolution, as manufacturing
concerns grew in size, their owners began to use
the service of hired managers. With this separation
of the ownership and management groups, the
absentee owners turned increasingly to auditors to
protect themselves against the danger of an
intentional errors as well as fraud committed by
managers and employees. Bankers were the
primary out side users of financial reports and were
concerned whether the repots were distorted by
errors or fraud.

7 10/5/2017
 Historical Devt cont..d
Some of the major auditing developments undertaken
since the 20th century are:
A shift in emphasis to the determination of fairness of
financial statements.
Increased responsibility of the auditors to third parties, such
as governmental agencies, investors, creditors, suppliers
and other members of the society who depend on the
auditors report to make various economic decisions.
A change in auditing method from detailed examination of
individual transactions and events to use of sampling
technique, including statistical and non statistical samplings.
Recognition of the need to consider the efficiency and
effectiveness of internal control as a guide to the direction
and amount of testing and sampling to be performed.
8 10/5/2017
 Historical Devt cont..d
Development of new auditing procedures applicable to
sophisticated computer systems, and use of the computer
as an auditing tool.
Recognition of the need for auditors to find means of
protecting themselves from the current wave of litigation.
An increased in demand for prompt disclosure of both
favorable and unfavorable information concerning any
publicly owned company.
An increased responsibility to assess the risk of material
fraud.
Increased demand for attestation by CPAs to
managements assertion about compliance with laws and
regulations and the effectiveness of internal control.

9 10/5/2017
 Nature and Definition of Auditing
Definition of Auditing- It is quite difficult to give a single
and precise definition of the term Audit. The word audit
has been defined by many distinguished authors and other
bodies, and every one of them has attempted to highlight
one aspect or the other, but the central idea is more or less
the same.
Definition 1: Some authors define auditing as an
independent examination of and expression of opinion on,
the financial statements of a concern by an appointed
auditor in pursuance of that appointment and in
compliance with any relevant statutory obligations.

10 10/5/2017
 Defn Cont..d
Definition 2: Some scholars also define auditing as an
independent examination of the books of account and
the related documentary evidence by a qualified person
in order to ascertain the accuracy of figures.
Definition 3: According to Montgomery, an American
Accountant & author, auditing is a systematic
examination of the books and records of a business of
other organizations in order to ascertain or verify and to
report upon the facts regarding the financial operations
and the results thereof.

11 10/5/2017
 Defn Cont..d
Definition 4: Spicer and Pegler in Practical Auditing
defines auditing as;
Auditing is an examination of books, accounts and
vouchers of a business, as will enable the auditor to
satisfy himself/herself that, the balance sheet is
properly drawn up so as to give a true and fair view of
the state of affairs of the business and whether profit
and loss account gives a true and fair view of the
profit or loss for the financial period, according to the
best of his information and the explanations given to
him and as shown by the books and if not in what
respect he is not satisfied.

12 10/5/2017
 Defn Cont..d
Definition-5: A special committee of the American Institute
of Accountants (AIA) has defined the term audit as
follows:
An audit is an attest function where by a Certified Public
Accountant (CPA) independently examine financial
information of an entity and produce a report on the
subject matter or an assertion about the subject matter
which is the responsibility of another party ( e.g.
Management).
-To attest the information means to provide assurance as
to its reliability. More formally, the AICPA has defined an
attest engagement as one in which:
- A practitioner is engaged to issue or does issue a written
communication that expresses a conclusion about the
reliability of a written assertion that is the responsibility of
13 another party. 10/5/2017
 Defn Cont..d
A financial statement audit is, by far, the most
common type of attest engagement. However,
CPAs attest to the reliability of a wide range of
other types of information, including financial
forecasts, internal control, compliance with laws
and regulations, advertising claims, and the like.
The amount of evidence obtained by the CPAs
and the content of the attest report depends on
the nature of the engagement. The standards of
the AICPA recognize three forms of attestation
engagements.

14 10/5/2017
 Defn Cont..d
These are:
Examination- An examination referred to as an audit
when it involves historical financial statements provides
the highest form of assurance that CPAs provide.
Review- A review is substantially lesser in scope of
procedures than an examination, and is designed to
lend only a limited degree of assurance.
Agreed upon procedures- if an examination
or review does not satisfy (meet) the clients
needs, the CPAs and the specified users of the
information may mutually decide on specified
agreed upon procedures that the CPAs will
perform.
15 10/5/2017
 Cont..d
Summary of the three attestation forms is given as follows:
Types of Level of assurance Nature of the Procedures
Engagement provided report

I) Examination High, provides Expresses Select from all available

reasonable an opinion (give procedure a combination
assurance positive that can limit attestation
risk to an appropriately
assurance)
low level.

II) Review Moderate or Express Generally limited to

Limited negative inquiry and analytical
Assurance assurance procedures
III) Agreed upon Varies with State findings Procedures agreed
procedures nature and extent no expression upon with the
of the procedures of opinion specified user(s)
performed

16 10/5/2017
 Nature of Auditing
From the foregoing discussion and other
definitions given by many scholars, auditing may
be stated as an independent, scientific, intelligent
and critical examination of the books of accounts
and records of businesses. Such examination
enables the auditors:
To satisfy himself that the balance sheet and the
profit and loss accounts are properly prepared as
per the requirement of GAAP.

17 10/5/2017
 Cont..d
The above statements i.e. balance sheet and profit and
loss account exhibit a true and fair picture of the financial
state of affairs of the business for the financial period.
Detection of errors and frauds is also part of auditing.
The job of auditing is performed by an independent
person or body of persons qualified for the job.
In order to report on the financial healthiness of a
business, the auditor will have to go through vouchers,
documents, information, and related evidence (internal
or external).
The auditor may sufficiently satisfy himself about their
correctness accuracy and authenticity and submit his
report accordingly.
18 10/5/2017
 Auditing differentiated from
bookkeeping, and Accountancy
In order to diagnose auditing in its correct perspective, one
must know how auditing different from book keeping, and
accountancy, and what relationship it has with other two.
Book keeping- As the expression implies it refers to
keeping the financial records (books) of a business or
other economic entity, recording all the transactions in
which it engages. In simple words, book keeping is
concerned with recording day to day business transactions
in the books of original entry and the ledger.
It is a part of accounting process, concerned only with the
original record of the transactions, which provides a base
for accounting. The major activity of book keeping either be
handle by book keeper or accounting machines.
19 10/5/2017
 Cont..d

Such activities involve:

Journalizing i.e. recording transactions in
the books of original entry.
Post them into different ledger kept for the
purpose
Taking total of different accounts in the
ledger and Balancing

20 10/5/2017
 Accounting vs. Auditing
Ideally, accounting begins where book keeping
ends and auditing begins where accounting ends.
Accountancy is the work of an accountant and is
confined mainly to the checking of the arithmetical
accuracy of the books of account, extraction of an
agreed trial balance, and preparation of financial
statements in such a way that one can clearly know
the state of affairs of the business.
Auditing involves a detailed and critical examination
and verification of such accounts by an independent
expert for the purpose of ascertaining the true and
correct position of a concern.

21 10/5/2017
 Cont..d
In short, an audit does not entail the
preparation of the accounts at all but denotes
something much wider, namely, the
examination of these accounts. The job of an
accountant is to record the transactions while
an auditor has to check and verify such
accounts. There cannot be auditing without
prior existence of accounts. Thus, the work of
an auditor is to begin only when the
accountant has finished his work.

22 10/5/2017
 Cont..d
Some accounting activities involves
Checking the work done by the book keeper
Preparing the trial balance
Preparing the trading or profit and loss accounts,
balance sheet, statements of owner equity or retained
earning , statements of cash flows and other related
reports
Passing entries for rectification of errors (correcting
entries) and making the necessary adjustments.
Review and interpretation of financial statements with
a view to help and guide management in formulation
of future policies of business
23 10/5/2017
 The Need for an Audit
Dependable information is essential to the very
existence of our society. This is because, reliable
information such as accounting and financial reporting
aid the society in allocating the limited resources in an
efficient manner so that the intended goal could be
effectively achieved by the end of the day.
Individual or group society members such as the
following depend on information provided by others in
the course of decision making activities.
Investors- to make decision to buy or sell securities.
Bankers and creditors- to decide whether to approve
a loan or not
24 10/5/2017
 Cont..d
Suppliers- to decide whether to supply goods and/ or
services on credit basis
Managers-to make wise economic decisions and to
monitor the performance of management at every
level within the organization.
Government agencies-to undertake various
regulatory actions
Labor unions to inter different contracts on the
behave of the employees
Other members of the society -to make decisions of
their respective interest.

25 10/5/2017
 Cont..d
Economic decisions are made under condition of
uncertainty. There is always a risk that the decision
makers select the wrong alternative and incur a
significant loss. The creditability added to the
information by auditors actually reduces the decision
makers risk. To be more precise, the auditors reduce
information risk, which is the risk that the financial
information used to make decisions is materially
misstated
.

26 10/5/2017
 Cont..d
Audited financial statements are the accepted
means by which business organization report their
operating results and financial positions. The word
audited when applied to financial statements, means
that the balance sheet and the statement of income,
retained earnings, and cash flows are accompanied by
an audit report prepared by independent public
accountants, expressing their professional opinion as
to the fairness of company financial statements

27 10/5/2017
 Cont..d
Financial statements prepared by management and
transmitted to outsiders without first being audited by
independent auditors (unaudited financial statements) leave
a credibility gap for all of the reasons such as (accidental
errors, lack of knowledge of accounting principles,
unintentional bias, and deliberate falsification). Due to such
reasons, financial statements may depart from Generally
Accepted Accounting Principles (GAAP), and some other
appropriate accounting base.
Auditors provide users with assurance that the financial
statements are free from all the above-mentioned problems
and thus, showing a true and fair picture of a business affair.
However, auditors cannot give certificate or guarantee as to
the correctness or accuracy of these statements, because,
they only depend on sample population.
28 10/5/2017
 Cont..d
Illustrations- A decision by a bank loan officer about
whether to make a loan to a business can be used to
illustrate the demand for auditing. Since the banks
objective is to get appropriate rate of interest and to
collect the principal of the loan at maturity, the loan
officer is making two related decisions i.e.
Whether to make the loan at all and,
What rate of interest adequately compensates the
bank for the level of risk assumed
The loan officer will make these decisions based on a
careful study of the companys financial statements
along with other information. Therefore, the risk
assumed by the banker actually has two components.

29 10/5/2017
 Cont..d
1)Business Risk- the risk that the company will not be able
to make periodic interest payments and repay the principal
at maturity because, because of economic condition, poor
management decisions and for some other reason. . This is
the chance a company takes that the customers will buy from
competitors, that product lines will become obsolete, that taxes
will increase, that government contracts will be lost, or that
employees will go on strike, etc. Thus management must have
timely, relevant, and reliable information for decision-making to
avoid, anticipate or compensate these risks.
Such risks are assessed by considering factors such as:
Financial position of the companies
The nature of its operation
The characteristics of the industry in which it is working
Quality and integrity of management
30 10/5/2017
 Cont..d
2) Information Risk- the risk that the information used
to assess business risk is not accurate. Information
risk includes the possibility that the financial
statements might contain material departure from
GAAP and other appropriate accounting basis.
If the loan officer has assurance from the auditors that
the companys financial statements are prepared in
accordance with generally accepted accounting
principles, he will have confidence in his assessment
of business risk. Moreover, the periodic audits made
after the loan has been made provide the loan officer
with a way of monitoring management performance
and compliance with the various loan provisions.
31 10/5/2017
 Cont..d
On the other hand, by reducing information risk, the auditors
reduce the overall risk to the bank; the company is more likely to
obtain the loan and it will be made at a lower rate of interest.
This is the risk (probability) that the information (mainly
financial) disseminated by a company will be materially false
or misleading.

This conflict of interests between preparers and users creates

a demand for independent persons as intermediary between
this two groups, i.e., to lend credibility to financial
statements. Thus the need for auditors arises.

32 10/5/2017
 Cont..d
Therefore, management of the company has an
incentive to provide audited financial statements
to the loan officer to obtain the loan and to get the
best possible interest rate.
NB. While auditing normally has only a limited
effect on a companys business risk, it can
significantly reduce the level of information risk.
The primary objective of auditing is verification of
accounts and statements while the subsidiary
objective is detection and prevention of errors
and frauds.
33 10/5/2017
 Some of the advantages of auditing may be summarized
as follows
Audited accounts are more readily accepted as
correct and authentic record of the transactions
Errors and frauds are detected and rectified in time
A regular audit would exercise a great moral influence
on the client a staff and thus prevent frauds and
errors. The staff will also keep the books of account
up to date.
An auditor possesses practical knowledge of business
finance, contract laws. He can therefore be an adviser
on these matters, which will help clients

34 10/5/2017
 Cont..d
An auditor acts as trustee (a person who has charge
of property in trust) of the shareholders and
safeguards their financial interest in the case of as
Joint Stock Company. Shareholders are assured that
the accounts have been properly maintained and
directors and manager of the company have not taken
any undue advantage of their position.
Audited accounts are considered more reliable for
taxation purposes ( sales tax, income tax etc.)
Audited accounts facilitate the settlement of accounts
between the partners, at the time of retirement or
death of partners.
Audited accounts are helpful in claiming reasonable
35 compensation from the insurance companies. 10/5/2017
 Adv..contd
Comparison can be made between the accounts of
the current year and other years.
Audited accounts can be very useful to secure loan,
to obtain extend credit, to admit a partner, to sell the
business or to convert it into a joint stock company or
to absorb or amalgamate different business or to
determine the purchase consideration.
As an appraisal function, audit reviews the existence
and operations of various controls and points out the
weaknesses and inadequacies.
Audit safeguards the interest of the worker since
audited accounts are useful to settle workers claim
for higher wages and bonus.
36 10/5/2017
 1.5. Types of Audits and Auditors
1.5.1. Types of audits-
The various types of audit that might be
undertaken by the auditor can be categorized as:
Audit of financial statements
Compliance audits
Operational audits

37 10/5/2017
 A. Audit of financial statements-
an audit of financial statements ordinarily covers
the balance sheet and the related income statements,
retained earnings /owners equity/, statements of cash
flows.
The goal is to determine whether these statements
have been prepared in conformity with generally
accepted accounting principles(GAAP).
Financial statement audits are normally performed
by firms of certified public accountants. Users of
auditors reports include management, investors,
bankers, creditors, financial analysts, government
regulators and other members of the society.
38 10/5/2017
 B. Compliance Audits-
Society has always concerned about compliance
with laws and regulations by all types of
organizations. As a result, compliance auditing has
evolved to become an important part of the work of
both external and internal auditors. Compliance
auditing is, therefore, the testing and reporting on
whether an organization has complied with the
requirements of various laws, regulations, polices,
procedures, and agreements.
E.g. The audit of an income tax return by auditors of
internal revenue services is to test whether tax returns
are in compliance with tax laws and internal revenue
service regulations.
39 10/5/2017
 C. Operational Audits-
The term operational audit refers to a comprehensive
examination of an operating unit or a complete
organization to evaluate its systems, controls, and
performance, as measured by management objectives.
An operational audit focuses on the efficiency and
effectiveness of operations.
Efficiency is success in using the available resources
to the best advantage of the organization.
Effectiveness is success in meeting ones stated goal
and responsibility. Operational audit is usually
performed by internal auditors of the organizations

40 10/5/2017
 1.5.2. Types of Auditors-
There are four types of auditors. Among these well
known types of auditors are:
I) Certified Public Accountants (External auditors),
II) Internal Auditors,
III) Auditors of the general accounting office(GAO),
and
IV) Internal revenue auditors (tax auditors)

41 10/5/2017
 Cont..d
I) Certified public accountants (External auditors)-These
are a group of auditors who examine the records
supporting the financial reports of an enterprise and give
an opinion regarding their fairness and reliability. They are
independent professionals who perform or render
professional service on a fee base, but not the employee of
the company being audited. They report their findings to
stockholders.
II) Internal auditors- The principal goal of the internal
auditors is to investigate and appraise the efficiency and
effectiveness with which the various organization units of
the company are carrying out their assigned functions.
-Even though internal auditors are not independent as in
the same sense as the independent public auditors, they
should be independent of the department heads and other
line executives whose work they review.
42 10/5/2017
 Cont..d
- Internal auditors report to the audit committee of the
board of directors, to the president or to other high
executives.
- Internal auditors are employee of the organization in
which they work and, thus, subject to rules and
regulations inherent in the employer- employee relation
ships.
-Large part of the work of internal auditors consists of
operational audit, they also conduct compliance audit
Internal auditing: Internal auditing is conducted by
employees of the business engaged in work on be half
of the organization. He is a salaried employee of the
business.
43 10/5/2017
 Contd
Internal audit has been defined as the independent
appraisal of activity within an organization for the view
of accounting, financial and other business practices as
a protective end constructive arm of management It is
type of control which functions by measuring and
evaluating the effectiveness of other types of internal
control.
Internal audit can be either pre-audit or post-audit. It
deals primarily with accounting and financial matters; it
may also properly deal with matters of an operating
nature. From the definition, it is clear that internal audit
not only includes the verification of accounting maters
but also financial & other matters.
44 10/5/2017
 Cont..d
The Internal auditor is responsible to:
Establish rules and procedures of the internal accounting
system.
Review the day-to-day financial operating procedures, and
to check of there is adequate supervision with a clear and
up to date supply of information to the management.
Evaluate the system of internal control.
Give periodic report to the management about the
financial condition of the organization.
Give recommendations about the improvement of
procedures.
Appraising the quality of performance in carrying out
assigned responsibilities.
Ascertain whether assets of the businesses are accounted
45
for & safeguarded from losses of all kinds. 10/5/2017
 Cont..d
III) Auditors of the general accounting office- Congress
or federal government has long had its own auditing staff,
headed by the controller general and known as general
accounting office, GAO auditor. The work of GAO auditors
includes audits of government agencies to determine the
spending programs, evaluate the efficiency and
effectiveness of selected government programs; audit of
financial statements of a number of federal agencies and
others.
IV) Internal revenue auditors (tax auditors) - The internal
revenue service is responsible for enforcement of the federal
tax laws.Thus, internal revenue auditors conduct compliance
audits of the income tax return of individual and corporations
to determine that income has been computed and taxes paid
as required by the federal law
46 10/5/2017
 Tips
THE NATURE OF EXTERNAL AUDITING IN ETHIOPIA
In Ethiopia audits seem to be done primary on
account of government regulation. For example,
NGOS are audited because the assets of the NGOS
are deemed a national asset, the use of which is
ultimately accountable to the government of
Ethiopia.Auditing in Ethiopia could be viewed in five
main areas.
The office of the auditor general (OAG)
The powers and functions of the office of the OG
are circumscribed through the proclamations that
established it, its sphere of activity lies in
47 government audit. 10/5/2017
 Cont..d
The audit service corporation. The duty and functions of
this entity involve mostly commercial audits of commercial
and productive enterprises wholly or partially owned by
government.
Private audit firms.
Ministry of finance audit and inspection.
Auditing activity in this area includes audit of ministries and
government departments by MF auditors and inspectors,
including tax audit by Inland Revenue authorities.
State corporations and enterprises auditors.
These are audits performed by internal auditors within
enterprise.

48 10/5/2017
 Chapter-2
Auditing Profession
 Chapter 2
Auditing Profession
Under this chapter;
The students will be able to identify and understand ;
o Generally Accepted Auditing Standards(GAAS)
General standards
Standard of field work
Standard of reporting
o Building blocks of a profession
o Professional ethics
o Legal responsibility and Liability

2 10/5/2017
 Introduction
The AICPA sets professional requirements for
CPAs, conducts research, and publishes materials on
many different subjects related to accounting, auditing,
attestation and assurance services, management
consulting services, and taxes. The AICPA also
promotes the accounting profession through organizing
national advertising campaigns, promoting new
assurance services, and developing specialist
certifications to help market and ensure the quality o
services in specialized practice areas. For example, the
association currently offers specialty designations in
business valuation, financial planning, information
technology, and financial aspects .
3 10/5/2017
 Cont..d
Four major areas in which the AICPA has authority to set
standards and make rules are as follows:
1.Auditing standards. The Auditing Standards Board (ASB) is
responsible for issuing pronouncement on auditing matters for all
entities other than publicly traded companies.
2. Compilation and review standards. The Accounting and Review
Services Committee is responsible for issuing pronouncements of the
CPAs responsibilities when a CPA is associated with financial
statements of privately owned companies that are not audited. In a
compilation service, the accountant helps the client prepare
financial statements without providing any assurance. In a review
service, the accountant performs inquiry and analytical procedures
that provide a reasonable basis for expressing limited assurance on
the financial statements.
4 10/5/2017
 Cont..d
3.Other attestation standards. Statements on Standards
for Attestation Engagements provide a framework for the
development of standards for attestation engagements.
4.Code of Professional Conduct. The AICPA Professional
Ethics Executive Committee sets rules of conduct that CPAs are
required to meet
Auditing standards are general guidelines to aid
auditors in fulfilling their professional responsibilities in
the audit of historical financial statements. They include
consideration of professional qualities such as
competence and independence, reporting
requirements, and evidence.
5 10/5/2017
 2.1 Generally Accepted Auditing Standards (GAAS)-
The existence of generally accepted auditing
standards is evidence that the accounting profession is
very concerned with maintaining a uniformity and high
quality of audit work by all independent public
accountants.
This will increase the prestige of the professional and
attributers increased significance by the public to the
auditors opinion attached to financial statements.

6 10/5/2017
 Cont..d
According, the AICPA has set forth the basic frame
work in the following 10- generally accepted auditing
standards which are grouped under three major
categories.
A. General standards
The audit is to be performed by a person or persons
having adequate technical training and proficiency as an
auditor.
In all matters relating to the assignment, independence
in mental attitude is to be maintained by the auditor or
auditors.
Due professional care is to be exercised in the
planning and performance of the audit and the
preparation of the report
7 10/5/2017
 Cont..d
B. Standards of field work
The work is to be adequately planned and assistants
if any are to be properly supervised.
Sufficient understanding of internal-control is to be
obtained to plan the audit and to determine the
nature, timing, and extent of tests to be performed.
Sufficient competent evidential matter is to be
obtained through inspection, observation, inquiries,
and confirmation to afford reasonable bases for an
opinion regarding the financial statements under
audits.

8 10/5/2017
 Cont..d
C. Standards of reporting
The report shall state whether the financial statements are
presented in accordance with generally accepted
accounting principles.
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.
Informative disclosures in the financial statements are
to be regarded as reasonably adequate unless other wise
stated in the report.
The report shall either contain an expression of
opinions regarding the financial statements taken as a
whole, or an assertion to the effect that an opinion can not
be expressed. When an overall opinion can not be
expressed, the reason therefore should be stated
9 10/5/2017
Brief explanation of the standards

(1)Training and proficiency- this requirement is

usually interpreted to mean college or university
education in accounting and auditing; participation in
continuing education programs and substantial public
accounting experience. A technical knowledge of the
industry in which the client operates is also part of the
personal qualifications of the auditors.
It follow that a CPA firm must not accept an audit
engagement without first determining that members of
its staff have the proficiency needed to function
efficiently and effectively in a given particular industry

10 10/5/2017
 Cont..d
(2) Independence- An opinion by independent public
accountant as to the fairness of a companys financial
statements is of a questionable value unless the
accountant is truly independent. Consequently, the
auditing standard that states in all matters relating to
the assignment, an independence in mental attitude is
to be maintained by the auditors is perhaps the most
essential factors in the existence of a public
accounting profession.
E.g. If an auditor own shares of stock in a company
that they audit, or if they serve as members of board of
directors, they might subconsciously biased in the
performance of an auditing duties.

11 10/5/2017
 Cont..d
An auditor is, therefore, expected to avoid any
relationship with a client that would cause an
outsiders who had a knowledge of all the facts to
doubt the CPAs independence (independence in fact
and independence in appearance should be
maintained).

12 10/5/2017
 Cont..d
(3) Due professional care- This standard requires the
auditors to plan and carry out every step of the
audit engagement in an alert and diligent manner.
Full compliance with these standards would avoid
or minimize any negligent acts or material
omissions by the auditors.
(4) Adequate planning and supervision-is essential
to a satisfactory audit. The appropriate number of
audit staff of various levels of skill and the time
required for each need to be determined in advance
of the field work. Staff members with limited
experience and new staff members if any should be
closely supervised while they are on work.
13 10/5/2017
 Cont..d
(5) Sufficient understanding of internal control- effective
internal control provides assurance that the clients
records are dependable and that its assets are protected.
When the auditors find this type of internal control, the
quantity of other evidence required is much less than if
control is weak. Thus, the auditors assessment of internal
control has great impact on the length and nature of the
audit process.
(6) Sufficient competent evidential matter-this standard
of field work requires that the auditors gather sufficient
competent evidence to have bases for expressing an
opinion on the financial statements. The term competent
refers to the quality of the evidence. Some evidential
matters are stronger and more convincing than others.
14 10/5/2017
 Cont..d
7-10) Standards of reporting-The four reporting
standards establish some specific directives for
preparation of the auditors report i.e.
The reports must specifically state whether the financial
statements are inconformity with GAAP.
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.
Consistency in the application GAAP and adequate
informative disclosure in the financial statements is to be
assumed unless the audit report states otherwise.
The report must contain an opinion on the financial
statements as a whole, or must disclaim an opinion.
15 10/5/2017
 Generally Accepted Auditing Standards (GAAS)

General Field Work

1. Adequate training 1. Proper planning 1. Statements prepared in

and proficiency and supervision accordance with GAAP
2. Circumstances when
2. Independence in 2. Internal control GAAP not followed
mental attitude understanding 3. Adequacy of disclosures
3. Due professional 3. Sufficient 4. Expression of opinion
care competent on financial statements
evidence
16 10/5/2017
 Auditing Profession
A profession that exists to serve the public must
ensure that its services are performed at the
highest level of independence, integrity, and
objectivity. This section explores the importance of
ethical behavior to organizations and auditors, the
principles used by the SEC and AICPA in
developing their rules concerning auditor
independence, and the AICPAs Code of
Professional Conduct.
A framework is also provided to help professionals
rationally resolve ethical dilemmas in situations not
covered by a code of ethics.
17 10/5/2017
 Cont..d
All recognized professions have recognized the importance of ethical
behavior and have developed codes of professional ethics. The
fundamental purpose of such codes is to provide members with
guidelines for maintaining a profession attitude and
conduct themselves in a manner that will enhance the
professional stature of their discipline.
The Mature of Ethics- Ethics has been defined as the study of
moral judgment and standards of conduct. While personal
ethics vary from individual to individual, at a point in time, most
within the society are able to agree as to what is considered ethical
and unethical behavior. In fact a society posses laws that define what
its citizens consider to be the more extreme forms of unethical
behavior.
18 10/5/2017
 Cont..d
But much of what is considered unethical in a particular society
is not specifically prohibited. Thus, a good starting point to
considering whether a given behavior is ethical or not is to
examine the context in which most ethical questions arise-
relationships among people. Any relationship between two or
more individuals such as a CPA and client carries with it sets of
expectation by each of the individuals involved.
Ethical Dilemmas- ethical dilemma is a situation that an
individual faces involving a decision about appropriate behavior.
A simple example of an ethical dilemma is presented below

19 10/5/2017
 Cont..d
Assume that a student at your University finds an
expensive watch in the University compound. What
action, if any, does the student take to find the
original owner?
Ethical dilemmas generally involve situations in which
the welfare of one or more other individuals is
affected by the results of the decision. In the dilemma
presented above, the welfare of the original owner of
the watch is affected by the students decision.
Ethical dilemmas faced by auditors often have an
effect on the welfare of a large member of individuals
or groups.

20 10/5/2017
 Cont..d
For example, if an auditor made an unethical decision
about the content of an audit report, the welfare of
thousands of investors, creditors and other members of
the society would be affected.
It is therefore essential for professions to have ethical
and moral standards in addition to other professional
and technical standards so that the profession can
provide quality services that can properly address the
interest and welfare of its users

21 10/5/2017
 Cont..d
The need for professional ethics
To understand the importance of a code of ethics
to public accountants and other professionals,
one must understand the nature of a profession
as opposed to other vocation.
There is no universally accepted definition of what
constitutes a profession; yet, for generations,
certain types of activities have been recognized
as professions while others have not.
22 10/5/2017
 Cont..d
Characteristics of a profession
The development of audit as a profession is tied to the
involvement of the importance of independence in audit. All
of the generally recognized professions such as auditing,
medicine, engineering, theology, architecture and the like are
characterized by the following elements/ features/.
Specialized body of knowledge- A highly developed
profession has a very highly specialized written body of
knowledge. The more the profession is highly developed, the
more specialized the body of knowledge and voluminous
requiring, longer period of time to absorb.
Always, there is need for technical competence and
familiarity with current/contemporary/ standards of practice
that might be embodied in the code of professional conducts.
23 10/5/2017
 Cont..d
Standards of qualification for admission- A profession to
be a profession must have well recognized and accepted
predetermined criterion of qualification for admission into the
profession. The standards include educational requirements
as well as other moral and legal criteria fulfillment. The
educational requirement is composed of theoretical
knowledge and practical experience. Thus, attaining a license
to practice as a certified public accountant requires an
individuals or group members, to meet minimum standards of
education and experience.
Standards of conduct of behavior- A profession has a
standard of conduct of behavior to be observed by the
professionals through prescribed code of ethics that attempt
to enforce general rules of conducts, and maximum and
minimum rules on competence and responsibility to client and
colleagues.
24 10/5/2017
 Cont..d
Level of status recognition- The quality and level of
professional services demanded by society determines the level
of status and recognition to the profession.
The level of status and recognitions earned in a society is a
function of the quality of professional services rendered which
in turn is a function of the standards of profession qualification
and the degree of the social, moral, and legal responsibility
assumed. (They have direct relation ship).
Thus, careless work or lack of integrity on part of any auditor(s)
may lead the public to negative view towards the entire
profession.

25 10/5/2017
 Cont..d
Acceptance of social responsibility/ Responsibility to
serve the public/ A professional to be a profession must accept
responsibility for the consequence of its action. Not only legal
responsibilities which arises out of contractual obligation, but also
moral responsibility to the profession it self and to the society at
large.
Accordingly, auditors are representatives of the public-creditors,
stockholders, consumers, employees, and others-in the financial
reporting process. The role of the independent auditors is to ensure
that financial statements are fair to all parties and not biased to
benefit one group at the at the expense of another. This responsibility
to serve the public interest must be a basic motivation for the
professional
26 10/5/2017
 The AICPA code of professional conduct
The AICPA code of professional conduct is designed to
provide a framework for expanding professional services and
responding to other changes in the profession, such as the
increasingly competitive environment.
The AICPA code of professional conduct consists of two
sections.These are:
Section-1:Principles- is a goal oriented, positively stated
discussion of the professions responsibilities to the public,
clients and fellow practitioners. It provides overall frame work
for the rules.
Section- 2: Rules- are enforceable applications of the
principles. They define acceptable behavior and identify sources
of authority for performance standards.
27 10/5/2017
 Cont..d
Responsibilities In carrying out their responsibilities as professionals, members
should exercise sensitive professional and moral judgments in all their
activities.
Public interest Members should accept the obligation to act in a way that will
serve the public interest, honor the public trust, and demonstrate
commitment to professionalism.
Integrity To maintain and broaden public confidence, members should perform
all professional responsibilities with the highest sense of integrity.
Objectivity and independence A member should maintain objectivity and be
free of conflicts in discharging professional responsibilities.
A member in public practice should be independent in fact and appearance
when providing auditing and other attestation services.
Due care A member should observe the professions technical and ethical
standards, strive continually to improve competence and the quality of
services, and discharge professional responsibility to the best of the members
ability.
Scope and nature of services 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 10/5/2017
28
 Cont..d
These principles of AICPA express the professions recognition of its
responsibilities to the public to clients, and to colleges.
They guide members in the performance of their professional
responsibilities and express the basic tents of the ethical and
professional conduct. The principles call for an unlimited
commitment to honorable behavior, even at the sacrifice of personal
advantages.These principles are explained below article by article.

Article-I: Responsibilities
In carrying out their responsibilities as professionals, members should
exercise sensitive professional and moral judgments in all their activities.

29 10/5/2017
 Cont..d
Article-II: The Public interest
Members should accept the obligation to act in a way that will serve the
public interest, honor the public trust and demonstrate commitment to
professionalism
A distinguishing mark of a profession is acceptance of its
responsibilities to the public. The accounting professions public
consists of clients, credit grantors, governments, employers,
investors, the business and financial community and others who rely
on the objectivity and integrity of certified public accountants to
maintain the orderly functioning of their business.

30 10/5/2017
 Cont..d
The public interest is thus defined as the collective well being of the
community of peoples and institutions the profession serves. Those
who rely on certified public accountants expect them to discharge
their responsibilities with integrity, objectivity, due professional, and
a genuine interest in serving the public i.e. they are expected to
provide quality services, enter into fee arrangements, and offer a
range of services- all in a manner that demonstrates a level of
professionalism consistent with these principles of the code of
professional conduct.

31 10/5/2017
 Cont..d
Article-III: Integrity
To maintain and broaden public confidence, members should perform all professional
responsibilities with the highest sense of integrity, i.e. a member shall be free of
conflict of interest, and /or not deliberately misrepresent facts or
subordinate his/ her judgments to others.
Article-IV: Objectivity and independence
A member should maintain objectivity and be free of conflicts of interest in
discharging professional responsibilities. A member in public practice should be
independent in fact and appearance when providing auditing and other attestation
services.
Article-V: Due professional care
A member should observe the professions technical and ethical standards, strive
continually to improve competence and the quality of services, and discharge
professional responsibilities to the best of the members ability.

32 10/5/2017
 Cont..d
Article-VI: Scope and Nature of services
A member in public practice should observe the scope and nature of services to
be provided.
Each of these principles should be considered by members in
determining whether or not to provide specific services in
individual circumstances. As there is no hard- and-fast rules that can
be developed to help members reach these judgments, they must be
sure whether they are satisfied that they are meeting the spirit of the
principles in this regards.
Section-II-Rules
Applicability-the bylaws of AICPA require that members adhere to
the rules of the code of professional conduct. Members must be
prepared to justify departures from these rules.
33 10/5/2017
 Cont..d
Rule -101: Independence
Independence is the cornerstone of the auditing profession.
Without it, the profession would not have the necessary credibility
to add value to corporate governance. Auditors must be
independent in fact and in appearance. To be independent in fact, auditors
must be objective and unbiased in their actions and evaluations and not be
influenced by management. Auditors must be professionally skeptical
as they gather evidence: they should not accept managements
explanations without corroborating evidence.
To meet the objective of independence in appearance, the auditors
must be perceived by knowledgeable users of financial statements as
independent.

34 10/5/2017
 Cont..d
A member in public practice shall be independent in the performance of
professional services as required by standards promulgated by bodies
designated by council.
Interpretation 101-1 of the code contains examples of
transactions, interests, and relationships that result in lack of
independency during the period covered by financial statements,
during the period of professional engagements, and / or at the
time of expressing opinion. These circumstances include the
following:
If a member or members firm had or was committed to acquire any
direct financial interest such as investment in the client ( owning capital
stock) and/ or acquire any material indirect financial interest (direct and
indirect financial interest)

35 10/5/2017
 Cont..d
If a member or members firm was a trustee of any trust or
executor or administer of any estate if such trust or estate, had or
was committed to acquire any direct or material indirect financial
interest in the enterprise to be audited.
Independency of partners and staff requires partners (or
stockholders), managerial employees and all professional staff be
free from any interest of the client enterprise. Thus, not all
employees of an audit firm are required to be independent.
If a member or members firm had any joint, closely held
business investment with the enterprise or with any officer,
director, or principal stockholders thereof that was material in
relation to the members net worth, or to the net worth of the
members firm.
36 10/5/2017
 Cont..d
If a member or members firm had any loan to or from the
enterprise or any officer, director, or principal stockholders
to the enterprise.
If a member or members firm was connected with the
enterprise as promoter, underwriter, or voting trustee, a
director or officer or in any capacity equivalent to that of a
member of management or of an employee.
If a member or members firm was a trustee for any pension
or profit-sharing trust of the enterprise.

37 10/5/2017
 Cont..d
Lack of independency may also arise from financial interests that may
result from past employment relationship with the client, interest of a close
relatives of an auditor such as her or his spouse and dependents. Other
situations that may impair independency of auditor are past due fees, gifts
from client, and client auditor or CPA litigation if any.
Two distinct ideas are involved in the concept of
independency.These are:
Independence in fact- AICPA (auditor) must in fact be independent
of any enterprise for which they provide attestation services i.e. an
auditor must be able to maintain an objective and impartial mental
attitude throughout the engagement.
Independent in appearance- The relationship between the CPAs
and their client must be such that the auditor will appear independent
to third party i.e. an auditor must be able to maintain an objective and
impartial mental attitude throughout the engagement.

38 10/5/2017
 Cont..d
NB. The independency rule does not apply to all services
performed by public auditor(s). Services in which the client is a
major beneficiary such as management consultancy service, tax
services, accounting/compilation/ service and the like do not
require independency.
The independency rule applies to auditing, and other attestation
services such as review of financial statements, examination of
financial forecasts, performance of agreed up on procedures and the
like.
Independency - a matter of degree i.e. the concept of independency
is not absolute; no CPA/auditor/ can claim complete independence
of a client. Rather, independence is relative i.e. a matter of degree.
Thus, CPAs must strive for the greatest degree of independence
consistent with this business environment. 10/5/2017
39
 Cont..d
Rule-102: Integrity and objectivity
In the performance of any professional service, a member shall maintain
objectivity and integrity, shall be free of conflicts of interest, and shall not
knowingly misrepresent facts or subordinate his/her professional judgments
to others.
Interpretation 102-1 states that a CPA or auditor(s) will be found
to have knowingly misrepresented facts in violation of rule102,
when he/she knowingly:
Makes, or permits or directs another to make, materially incorrect
entries in a clients financial statements or records.
Fail to correct financial statements that are materially false or
misleading when the member has such authority.
Signs or permits or directs another to sign, a documents
containing materially false and misleading information.
40 10/5/2017
 Cont..d
Rule-201: General standards
A member shall comply with the following standards and with any
interpretations thereof by bodies designated by council.
Professional competence- undertakes only those
professional services that the member or members firm can
reasonably expect to be completed with professional
competence.
Due professional care- Exercise due professional care in the
performance of professional services.
Planning and supervision- adequately plan and supervise
the performance of professional services.
Sufficient relevant data- Obtain sufficient relevant data to
afford a reasonable basis for conclusions or recommendations in
relation to any professional services performed.
41 10/5/2017
 Cont..d
Rule-202: Compliance with standards
A member who performs auditing, review, compilation, management
consultancy, tax return preparation, or other professional services shall
comply with standards promulgated by bodies designated by council.
Rule-203: Accounting Principles
A member shall not (1) express an opinion or state affirmatively that the
financial statements or other financial data of any entity are presented in
conformity with GAAP or (2) state that he/she is not aware of any
material modification that should be made to such statements or data in
order for them be in conformity with GAAP, if such statements or data
contain any departure from accounting principles promulgated by bodies
designated by council.

42 10/5/2017
 Cont..d
Rule-304: Confidential client information
A member in public practice shall not disclose any confidential client
information without the specific consent of the client.
This rule shall not be construe:
To relieve a member of the members professional obligations under
rule 202 and 203 presented above.
To affect in any way the members obligation to comply with a
validity issued and enforceable subpoena or summons
To prohibit review of a members professional practice under AICPA
or state CPA society authorization, or
To preclude a member from initiating with or responding to any
inquiry by a recognized investigative or disciplinary bodies.
43 10/5/2017
 Cont..d
Confidential vs. privileged communications-The communication
between CPAs and their clients are confidential, but not privileged.
This is because; legally privileged communications can not be
required by a subpoena or court order. Thus, CPAs may be compelled
to disclose their communication with clients in certain types of court
proceedings
Reporting illegal act many countries have adopted laws that require
members in a public practice (auditors) to reports illegal acts committed
by organizations when ever they come across it if:
It has a material effect on the financial statements
Senior management and the board directors have not taken appropriate
remedial action
The failure to take remedial action is reasonably expected to warrant a
departure from standards of audit report or a resignation by the
44 10/5/2017
auditors.
 Cont..d
Rule-302: Contingent fees
A member in public practice shall not perform for an contingent fee any
professional services for, or receive such a fee from a client for whom the
member or members firm performs services such as:
(a) An audit or review of financial statements
(b) Compilation of financial information expected to be used by third
party,
(c) An examination of prospective financial information or
(d) Prepare an original or amended tax return or claim for a tax refund.
A contingent fee is a fee established for the performance of any
service pursuant, or an arrangement in which no fee will be charged
unless a specified finding or result is attained, or in which the amount
of the fee is otherwise dependent upon the finding or result of such
services.
45 10/5/2017
 Cont..d
Rule-501: Acts-Discreditable
A member shall not commit an act discreditable to the profession
Rule-501 gives the AICPA the authority to discipline those
members who act in a manner damaging to the reputation of the
profession. The three circumstances outlined in interpretation 101-1
presented above relating to misleading entries and financial
statements are considered discreditable acts
An interesting practices have been interpreted to be discreditable
is failure to return client records, may be when the auditors
discharges their responsibilities and not been paid for their services.
To refuse to return a clients ledger or other records is clearly wrong
but refusing to return audit work papers needed by client is not
constitutes acts discreditable, because, audit work paper is the
property of the auditors not the property of the client company
46 10/5/2017
 Cont..d
Rule-502: Advertising and other forms of solicitation
A member in public practice shall not seek to obtain clients by advertising or other
forms of solicitations in a manner that is false, misleading, or deceptive. Solicitation
by the use of coercion, overreach or harassing conduct is prohibited.
Rule-503: Commission and Referral fees
Prohibited commissions- a member in public practice shall not for a
commission recommend or refer to client any product or service, or for a
commission recommend or refer any product or service to be supplied by a client, or
receive a commission, when the member or the members firm also performs for that
client, services such as auditing and review of financial statements, a compilations
of financial statements and/ or examination of financial statements.
Disclosure of permitted commissions and referral fees- a member of CPA
or auditor who receive/or paid a permitted commission and/or referral fees shall
disclose such acceptance or payments to the client
47 10/5/2017
 Cont..d
Rule-505: Form of organization and Name
A member may practice public accounting in a form of organization
permitted by law or regulation whose characteristics conform to resolution
of council.
A member shall not practice public accounting under a firm name that is
misleading.

48 10/5/2017
 Cont..d
2-4: Legal liabilities and responsibilities of auditors
We live in an era of litigation in which persons with real or
fancied grievances are likely to take their complaints to court. In
this environment, investors and creditors who suffer financial
damages or reversals find CPAs, as well as attorneys and corporate
directors, tempting targets for lawsuits alleging malpractice.
Thus, CPAs must approach every engagement with the prospect
that they may be required to defend their work in court. Even if the
court finds in favor of the CPAs, the costs of defending a legal
action can be very high. Moreover, lawsuits can be extremely
damaging to a professionals reputation. In extreme cases, the CPA
may even be held criminal for professional malpractice

49 10/5/2017
 Cont..d
Though audit report is not a guarantee that the figures are free from
error, the auditor must conduct the audit that it stands a reasonable
chance of discovering a material error in the figure. It is difficult to
determine what is meant by reasonable skill and care. The auditors
principal duties center around the report on the truth and fairness of the
financial statements.
Discussion of Auditors liabilities is best prefaced by a definition of some
of the common business law terms such as negligence, liability for gross
negligence, liabilities for fraud, and liabilities for constructive fraud.
Negligence- also referred to as ordinary or simple negligence is
violation of a legal duty to exercise a degree of care that an ordinary
prudent person would exercise under similar circumstances. For an
auditor, negligence is failure to perform a duty in accordance with
applicable standards such as failure to exercise due professional care.
50 10/5/2017
 Cont..d
Gross Negligence- is the lack of even slight care, indicative of
reckless disregard for ones professional responsibilities.
Substantial failures on the part of an auditor to comply with
GAAS might be interpreted as gross negligence.
Fraud-is defined as misrepresentation by a person of a material
fact, known by that person to be untrue or made with reckless
indifferences as to whether the fact is true with the intention of
deceiving the other party and with the result that the other party
is injured.
Constructive fraud- differs from fraud as defined above in that
constructive fraud does not involve a misrepresentation with
intent to deceive. Gross negligence on the part of an auditor as
been interpreted by the courts is constructive fraud.
51 10/5/2017
 Cont..d
Probity- is the relationship between parties to contract. A CPA
firm is in probity with the client it is serving, as well as with any
third party beneficiary.
Breach of contract- is failure of one or both parties to a
contract to perform in accordance with the contacts provisions.
E.g. Failure by auditors(s) to perform in accordance with
contractual specifications indicated in the engagement letter.
Proximate/immediate/ cause-exists when damage to
another is directly attributable to a wrong doers act. The issue of
proximate cause may be raised as a defense in litigation cases.
Even though the CPA firm might have been negligent in
rendering services, it will not be liable for the plaintiffs loss if its
negligence was not the proximate cause of the said loss.
52 10/5/2017
 Cont..d
Contributory negligence-is negligence on the part of the
plaintiff that has contributed to his or her having incurred loss.
Comparative negligence- is a concept used by courts to
allocate damages between negligent parties based on the degree
to which each party is at fault. The allocation of damages is also
referred to as proportionate liabilities.
The plaintiff-is the party claiming damages and bringing suit
against the defendant.
A third party beneficiary- is a person or institution not a
contracting party who is named in a contract or intended by the
contracting parties to have definite rights and benefits under the
contract

53 10/5/2017
 Cont..d
. E.g. If W-Thomas audit firm is engaged to audit the financial
statements of Shell- Ethiopia and if it is indicated in the contract
that a copy of the audit report will be sent to Awash International
Bank as a support for a loan, then, the bank is a third-third party
beneficiary under the contractual agreement between W-Thomas
Audit firm and Shell-Ethiopia company.
An engagement letter- is the written contract summarizing
the contractual relationships between the CPA and client. It
typically specifies the nature and scope of professional services to
be rendered , expected completion date of the engagement, the
amount of audit fees, responsibility of auditors and responsibility
of client/manager/ and other related matters.

54 10/5/2017
 Cont..d
In other words, if his client suffers any loss due to his negligence
or breach of trust or duty and, the errors or frauds remain
undetected, he would be held liable for the same and may be
called upon to pay the damages suffered by the client on account
of his negligence or breach of duty. The auditor may be penalized
for failing to apply reasonable care and skill. This could take the
form of a disciplinary action by the professional body or civil or
criminal proceedings.

55 10/5/2017
 Cont..d
Auditors liability can be classified as:
1. Auditors civil liability
The civil liability of an auditor can be for
Liability for negligence
Liability for Misfeasance.

A. Liability for negligence: An auditor is appointed to

perform certain specific duties and in performing his duties he
must exercise reasonable care and skill to perform his duties for
which he is employed. If he acts negligently on account of which
the client is made to suffer loss, the auditor may be held liable
and may be called upon to make good the damages, which the
client suffered due to this negligence. The auditor can be held
liable if the following conditions are satisfied.
56 10/5/2017
 Cont..d
There should be sufficient ground for holding him liable for
negligence. A general charge will not be enough and the specific
matter in respect of which he failed must be indicated
It must be proved that the client has suffered a loss on account
of this negligence
B. Liability for breach of contract /Misfeasance /:
The term misfeasance implies breach of trust or breach of
duty. An auditor has to perform certain duties, which may
arise out of the contract with the client as in the case sole
proprietor or partnerships or it may be statutory as laid
down in the various statutes. If the auditor does not perform
his duties properly and as a result his client suffers a loss, he
may be held liable for misfeasance.
57 10/5/2017
 Cont..d
2. Auditors criminal liability: Criminal liability of an auditor
arises because of offences against the statutory provisions specifically
laid down. In such cases, an auditor is liable not only to the
shareholders but also to the state. It may arise because of some
criminal at on his part or gross neglect of certain provisions of the
statute. In case of criminal liability, an auditor is punishable with fine
or imprisonment or both as might be provided in the relevant statute.

58 10/5/2017
 Cont..d
3. Auditors contractual liability: The contractual liability arises
out of the contract entered between the auditor and the client. This
arises when there is no statute governing the rights or duties of an
auditor. Since there are no statutory provisions, the question of
liability has to be settled in accordance with the terms and
conditions settled by the auditor with his client in the agreement.
Hence the agreement with the auditor has to be in written clearly
specifying the terms of duties, responsibilities and scope of the audit.

59 10/5/2017
 Under this unit, students will be able to;
explain the meaning and significance of internal
control;
Discuss the major components of a clients internal
control structure; and
To show how auditors go about obtaining and
understanding of internal control to meet the
requirements of the second standard of field work

2
 Cont..d
4.1 Definition of internal control
Differences of opinion have long existed about the
meaning and objectives of internal control.
Many people interpret the term internal control as the
steps taken by a business to prevent fraud-both
employee fraud and fraudulent financial reporting.

Others, while acknowledging the importance of internal

control for fraud prevention, believe that internal control
has an equal role in assuring control over manufacturing
and other processes.

3
 Contd
The system of internal control is the plan of the
organization and all the methods and procedures
adopted by the management of an entity to assist in
achieving managements objective of ensuring, as far
as practicable, the orderly and efficient conduct of its
business.
In other words internal control is defined as a
process, effected by the entitys board of directors,
management, and other personnel, designed to
provide reasonable assurance regarding the
achievement of objectives in the following categories:
- Effectiveness and efficiency of operations
- Reliability of financial reporting
- Compliance with applicable laws and regulations
4
 Contd
The internal control structure policies and
procedures designed to safeguard assets against
loss from errors and irregularities are ordinarily
relevant to audit.

5
 Objectives of internal control systems
. The following are the objectives of internal control system:
Adherence to the policies and procedures laid down by
the management i.e. proper authorization of
transactions and activities.
Safeguarding the assets of the enterprise
Prevention and detection of fraud and error
Accuracy and completeness of records i.e. all
transactions are recorded correctly and as necessary
to permit the preparation of reliable financial
statements and maintain accountability for assets
(timely and accurate recording of transactions in the
correct period
Timely presentation of reliable financial and other
information
6
 Contd
Purpose of internal control
To plan the audit and determine the nature, timing and
extent of audit procedures
To aid management in information, protection and
control.
To protect assets from theft, loss, damage, spoilage
wastage etc
To prevent errors and frauds in advance before they
occur
To assure accuracy and dependability of personnel and
financial operation information
To monitor operating efficiency
To monitor adherence to prescribed policy and
procedures
To provide evidence of responsibility.
7
 Cont..d
Essential elements of sound internal control
Adequate and competent personnel
Separation of custodianship, operations and
record keeping
Proof of work done (documentary evidence)
Adequate and appropriate physical protections of
assets and records
Assurance of mechanical accuracy
Assurance of efficiency and effectiveness

8
 Cont..d
Specific internal control procedures include
Reporting, reviewing and approving reconciliations
Checking the arithmetical accuracy of the records
Controlling applications and the environment of computer
information.
Maintaining and reviewing control accounts and trial balances
Approval and control of documents
Comparing internal data with external sources of information
Comparing the results of cash, security and inventory counts with
accounting records
Limiting direct physical access to assets and records
Comparing and analyzing the financial results with budgeted
amounts and so on.

9
 TYPES OF INTERNAL CONTROL
An internal control system has a wide coverage that
extends beyond those matters, which relate directly to
the functions of the accounting system and from this
angle, the internal control system can be divided into
two categories.
Accounting controls
Administrative controls
1) Accounting controls-Those controls which are related to
the accounting system is known as the accounting controls and
has the following objectives:
Transactions are executed in accordance with the managements
authorization, i.e. in accordance with the laid down policies and
procedures
Transactions are promptly recorded in a proper manner and the
purpose is to facilitate the timely preparation and communication of
reliable financial information.
Accountability for assets is maintained and assets are safeguarded
from unauthorized access, use or disposal.
10
 Cont..d
To achieve the objectives of internal control system,
it is necessary to establish adequate policies and
procedures. While the specific control policies and
procedures depend on the nature of the transactions,
manner of information processing and similar factors,
most of theses policies and procedures generally fall
into the following categories
Segregation and rotation of duties
Authorization of transactions
Maintenance of adequate records and documents
Accountability for and safeguarding of assets
Independent checks on performance
11
 Cont..d
2) Administrative controls-It comprises of
internal controls other than accounting controls.

The maintenance of records giving details of

customers contacted by the salesmen and the
system of a periodic review by specially
designated authorities, the adequacy of the action
taken on the customers complaints are the
example of administrative control

12
 Cont..
4.3 Components of Internal Control
For the purpose of financial audits, the policies and
procedures used by an entity to achieve internal
control are referred to as the entitys internal control
structure.
Internal control structure vary significantly from one
organization to the next, depending on such factors as
the size, nature of operations, and objectives of the
organization for which the structure was designed.
The internal control structures of all organizations
include five components. These are:
The control environment
Risk assessment
The accounting information and communication system
Control activities; and
Monitoring
13
 Cont..d
4.3.1 CONTROL ENVIRONMENT
The control environment sets the tone of an
organization by influencing the control consciousness
of the people. It is viewed as the foundation for the
other components of internal control. The following are
the major control environment factors
I) Integrity and Ethical values-the effectiveness and
efficiency of the internal control structure,
Management should establish behavioral and ethical
standards that discourage employees from engaging
in activities that would be considered dishonest,
unethical or illegal. The standards must be
communicated by appropriate means and also remove
and reduce the temptations and incentives to engage
in such behavior.
14
 Cont..d
II. Commitment to competence- the employees employed
must be competent enough to perform the assigned tasks. They
must posses the skills and knowledge essential for the performing
the jobs and also in applying the internal control policies and
procedures.
The employees appointed should have adequate education and
experience and also should provide adequate training and
supervision.

15
 Cont..d
III. Board of Directors or Audit Committee-the effectiveness of
the Board of Directors or Audit Committee will significantly
influence the control environment. The independence of the Board of
Directors or the Audit Committee enables it to be effective at
overseeing the quality of the organizations financial reports, and act
as a deterrent to management override of internal controls and to
management fraud.

16
 Cont..d
IV.Managements philosophy -management philosophies will differ
towards financial reporting and towards taking business risks. Some may be
very aggressive in financial reporting and may be willing to take great risks,
while others may be conservative and risk adverse. The differing
attitudes and styles may have an impact on the overall reliability of
the financial statements. The internal control in an informal
organization will be implemented by face to face contact with
employees and in formal organization, it will establish written
policies, performance reports, and exception reports to control its
various activities.

17
 Cont..d

V. Organizational structure- A well-designed organizational

structure provides a basis for planning, directing, and controlling
operations. It divides authority, responsibilities and duties among
members of the organization by dealing with such issues as
centralized versus decentralized decision-making and appropriate
segregation of duties among the various departments.
When the management decision-making is centralized and
dominated by one individual, that the individuals moral character
is extremely important to the auditors. When decentralized
style is used, procedures to monitor the decision making of the
many managers involved become equally important.

18
 Cont..d
VI) Human resource policies and procedures-the managements policies
and practice for hiring, training, evaluating, promoting and compensating
employees have a significant effect on the effectiveness of the control
environment. Effective human resource policies often can reduce
or sometimes remove other weaknesses in the control environment

19
 Cont..d
VII) Assignment of Authority and responsibility
The employees in the organization should have
a clear understanding of their responsibilities and
rules and regulations that govern their actions. To
enhance the control environment, the
management should develop employee job
descriptions and should define clearly the authority
and responsibility within the organization.

20
 Cont..d
4.3.2 RISK ASSESSMENT
The management should carefully consider the factors
that affect the risk of an organization. The risks affecting
the preparation of financial statements in accordance with
the generally accepted accounting principles (GAAP)
should be considered in the financial reporting objective.
The factors that affect the increased financial reporting
risks are the following:
Changes in the organizations regulatory or operating environment
Changes in personnel
Implementation of a new or modified information system
Rapid growth of the organization
Changes in technology affecting production process or information
system
21
Introduction of new lines of business, products or process
 Cont..d
4.3.3. THE ACCOUNTING INFORMATION AND
COMMUNICATION SYSTEM
Accounting information and communication systems
capture, process, and report information to be used by
parties both within and outside the organization. An
organizations accounting information system consists
of the methods and records established to identify,
assemble, analyze, classify, record, and report an
entitys transactions and to maintain accountability for
the related assets.

22
 Contd
Accordingly, an accounting information system should:
Identify and record all valid transactions.
Describe on a timely basis the transactions in
sufficient detail to permit proper classification of
transactions for financial reporting
Measure the value of transactions in a manner that
permits recording their proper monetary value in the
financial statements.
Determine the time period in which transactions
occurred to permit recording of transactions in the
proper accounting period.
Present properly the transactions and related
disclosures in the financial statement
23
 Cont..d
4.3.4. CONTROL ACTIVITIES
The policies and procedures that help the
management to carry out the directives are known as
the control activities. These policies and procedures will
help the management to ensure that the actions are
taken to address the risks that affect the organization.
The following are the control activities that are relevant
to an audit of the organizations financial statements:
Performance reviews
Information processing
Physical controls
Segregation of duties

24
 Cont..d
I)Performance review- these controls include
reviews of actual performance as compared to
budgets, forecasts, and prior period performance:
relating different sets of data to one another; and
performing overall review of performance.

Performance review provides management with an

overall indication whether personnel at various levels
are effectively pursuing the objectives of the
organization.

25
 Cont..d
II) Information processing- the control activities are
performed to check the accuracy, completeness,
and authorization of transactions and information
processing control is one of them. The information
processing control has two broad categories and
they are:
- General control: which apply to all information
processing activities and
- Application control: which apply only to single
application

26
 Cont..d
Another control over information processing is a
system of well designed forms and documents. In the
case of a credit sales transaction, the accounting
department receives copies of internal documents
prepared by the sales, credit, and shipping departments
to properly record the transaction.
III) Physical controls- These control activities include
the physical security over both records and other
assets. Safeguarding of records may include
maintaining control at all times over unissued
renumbered documents, as well as other journals and
ledgers, and restricting access to computer programs
and data files
27
 Cont..d
IV) Segregation of duties- a fundamental concept of
internal control is that no one department or person
should handle all aspects of a transaction from
beginning to end. In similar manner, no one individual
should perform more than one of the functions of
authorizing transactions, recording transactions, and
maintaining custody over assets. Also, to the extent
possible, individuals executing the specific transaction
should be segregated from these functions.
The goal is to reduce the opportunities for any one
person to be in a position to both perpetrate and
conceal errors or irregularities in the normal course
to his or her duties.
28
 Conts
4.3.5. MONITORING
Monitoring is a process that assesses the quality of
the internal control structure over time and it is the last
component of internal control. The monitoring of the
internal control structure is important to determine
whether it is operating as intended and whether any
modifications are necessary. Monitoring can be
achieved by

Ongoing monitoring activities include regularly

performed supervisory and management activities
such as continuous monitoring of customer
complaints or reviewing the reasonableness of
the management reports.
29
 Cont..d
Separate evaluations are monitoring activities
that are performed on a non- routing basis,
such as periodic audits by the internal
auditors.
- Internal auditors investigate and appraise the
internal control structure and the efficiency with
which the various units of the organization are
performing their assigned functions, and report
their findings and recommendations to the top
management.

30
 Cont..d
Internal Control and External Audit
The external auditor interest in internal control is in order to
determine the extent of reliability of organizations results and
its effectiveness of control of its operations. To this end the
external auditor reviews the internal control
(a)To understand the existing control systems and
procedures,
(b)To evaluate its adequacy in fulfilling internal control
objectives, by identifying weaknesses and strengths
Internal Control vs. Internal Audit
The objective of internal audit is to investigate and
appraise the system of internal control and the efficiency
with which the various unit of the business are
performing there assigned function and to report their
findings and make recommendations to top
31
management.
 Cont..d
Internal auditor aid the management in achieving the
most efficient administration of the business. They
appraise the effectiveness of internal control in various
departments, branches or other organizational unit of
the organization.
Internal auditors work is not limited to accounting
controls.
A fundamental concepts of internal control is
segregation of duties (no one person or department
should handle all aspects of a transaction from
beginning to the end ).

32
 Cont..d
Documentations of Internal Control
To facilitate the accumulative of the information
necessary for the proper review and evaluation of
internal controls, the auditor can use one of the
following which helps him to know and understand the
system and evaluate it:
Narrative record;
Check list;
Flow chart and
Questionnaire;

33
 Cont..d
Narrative Notes
This is a simple and apparently convenient way of
describing systems. Having ascertained the system, the
auditor draws up a narrative description of it for the
audit files.
The narrative record is a complete and exhaustive
description of the system as found in operation by the
auditor. Actual testing and observation are necessary
before such a system is in operation and would be
more suited to small business.

34
 Cont..d
Advantages of narrative records are;

To identify weaknesses or gaps in the system

To incorporate changes arising on account of
reshuffling of man power, etc.
Disadvantages

Notes can take up a disproportionate amount of

space
Notes may be difficult to interpret
What happens it if personnel change?

35
 Cont..d
Check-lists
It is a series of instructions or questions on internal
control which the auditor must follow or answer. When a
particular instruction is carried out, the auditor initials
the space opposite the instruction. If it is in the form of a
question the answer generally Yes, No or Not
Applicable is entered opposite the question.

A check list is more in the nature of a reminder to the

auditor about the matters to be checked for testing the
internal control system.

36
 Contd
A few examples of check list instruction are given
here under:
Are the purchases made on the basis of a written
order?
Is the purchase order form standardized?
Are purchase order forms are pre-numbered?
Are the inventory control accounts maintained by
persons who have nothing to do with: Custody of
inventory; Receipt of inventory; Inspection of
inventory; and Purchase of inventory?

37
 Cont..d
Flowcharts
This is becoming an increasingly widely used technique
for recording accounting systems in audit files.
It is a graphic presentation of internal controls in the
organization and is normally drawn up to show the controls
in each section or sub-section.
As distinct from a narrative form, it provides the most
concise and comprehensive way for reviewing the
internal controls and the evaluators findings. In a flow
chart, narratives, though cannot perhaps be totally
banished are reduced to the minimum and by that process,
it can successfully bring the whole control structure,
specially the essential parts thereof, in a condensed but
wholly meaningful manner.
38
 Cont..d
Advantages of flow charts
They describe the flow of documents through the
system and enable the auditor to relate those
movements with procedures and checks carried out
as part of that system.
When properly prepared, it shows the sources and
destinations of all documents will be clear .
They assist to highlight weaknesses in the control of
the business.
They enable audit tests to be clearly related to
weaknesses in the accounting system.

39
 Cont..d
Questionnaires
A questionnaire is a set of questions framed in an
organized manner, about each functional area, which
has as purpose the evaluation of the effectiveness of
control and detection of its weakness if any.
- it usually consists of several separate sections
devoted to areas such as purchases, sales, debtors,
creditors, wages, etc.
- It is intended to be filled by the company executives
who are in charge of the various areas.

40
 Cont..d
However, this poses some practical difficulties.
The questionnaire is to travel from executives and,
therefore, it may take a pretty long time to be filled
May not be readily intelligible/Understandable to
busy executives
There is a possibility of the questionnaire being
misplaced while travelling from one table to another.
Having regard to these difficulties, it is now almost an
accepted practice that the auditor (or his representative)
arranges meetings with the executives concerned and
gets the answers filled by each executive.
-Questions should be consistent, sequential, logical, and
if
41
possible corroborative.
 Limitations of Internal Control
An internal control system should be designed and
operated to provide reasonable assurance that an
entitys objectives are being achieved.
The concept of reasonable assurance recognizes
that the cost of an entitys internal control system
should not exceed the benefits that are expected to be
derived.
Balancing the cost of controls with the related benefits
requires considerable estimation and judgment on the
part of management. The effectiveness of any internal
control system is subject to certain inherent limitations,
including management override of internal control,
personnel errors or mistakes, and collusion.
42
 Some limitations

Internal control is not simple; it should be complex

as it involves division of functions and allocation of
responsibilities into many different people and units
involving greater paper work leads to excessive control.
Internal control can not give the auditor all the
reliance needed but can only provide reasonable
assurance but not complete reliance to be placed.

43
 Cont..d
Human judgment in decision making or simple
mistakes or errors may cause inefficiency in the
internal control system
e.g. error in system design, lack of complete
understanding of a given process, improper
implementation of designed system, error in
understanding of interpreting reports generated, e.t.c
Collusion of two or more people circumvent/out fit
the internal control system.
inappropriate override of internal control by
management also weakens internal control

44
 Cont..d
Custom, culture and corporate governance system
and an effective control environment reduces the risk
of fraud but it is not full proof against fraud. On the
other hand the opposite is true when the entitys culture
tolerates material misstatements.
Qualitative
and quantitative estimates made by
management in evaluating cost-benefit relationship of
internal control. Internal control can be costly as it may
entail increased personnel and or sophisticated
techniques of control.
Or The internal control adopted by a business also is
limited by cost considerations-cost- benefit analysis
required)
45
 Cont..d
Mistakes may be made in the performance of internal
control policies and procedures as a result of
misunderstanding of instructions, mistakes of
judgment, carelessness, distraction, or fatigue.

46
 Auditors consideration of internal control
The auditors understanding of their clients internal
control provides a basis both to
(1) Plan the audit, and
(2) Assess control risk.
1) Plan the audit,
In planning an audit ,it is essential that the auditors
have a sufficient understanding of the clients internal
control structure. This encompasses both an
understanding of the design of the policies,
procedures, and records, and a knowledge of
whether they have been placed in operation by the
client.

47
 Cont..d
The auditors understanding of internal control is a
major factor in determining the nature, timing, and
extent of substantive testing necessary to verify the
financial statements assertions.
In planning the audit, that knowledge is used to:
Identify types of potential misstatements
Consider factors that affect the risk of material
misstatements
Design substantive tests.

48
 Cont..d
They also consider their assessment of inherent risk,
judgments about materiality, and the nature of the
entitys operations
In any case, the auditors understanding of the
internal control structure must encompass issues
such as:
The control environment
Risk assessment
The accounting information and communication
system,
Control activities and,
Monitoring

49
 Cont..d
While obtaining an understanding of internal
control, the auditors may also obtain evidence
about the operating effectiveness of various
controls. Operating effectiveness deal with:
How a control is applied,
The consistency with which it is applied, and
Who applies the control

50
 2) Assess control risk
The auditors wish to assess control risk at a level
lower than the maximum, they must have evidence
of the operating effectiveness of the controls. This
evidence is obtained by performing tests of controls.
Documentation of the understanding of the
internal control structure- with their working paper-
The documentation usually takes the form of
internal control questionnaires, written narratives, or
flowcharts.
Walk-Through - verify that the system has been
placed in operation by performing a walk-through of
each transaction cycle; refers to tracing several
transactions (perhaps only one or two) through each
step in the cycle.
51
 Cont..d
Revenue ( or sales and collections) cycle- from
customers, approving credit, shipping merchandize,
preparing sales invoices (billing), recording revenue
and accounts receivable, and handling and recording
cash receipts

Acquisition ( or purchases and disbursements ) cycle-

purchased of inventory, other assets, and services;
placing purchase orders, inspecting goods upon
receipt, and preparing receiving reports; recording
liabilities to vendors; authorizing payments; and
making and recording cash disbursements.

52
 Cont..d
Conversion (Transaction) cycle-including
procedures and policies for storing materials, placing
materials into production, assigning production cost
of inventories, and accounting for the cost of goods
sold.
Payroll cycle-including procedures and polices for
hiring, terminating, and determining pay rates;
timekeeping; computing gross payroll, payroll taxes,
and amounts withheld from gross pay; maintaining
payroll records and preparing and distributing
paychecks.

53
 Cont..d
Financing cycle-including procedures and policies
for authorizing, executing, and recording
transactions involving bank loans, leases, bonds
payable, and capital stock.

Investing cycle-including procedures and polices

for authorizing, executing, and recording
transactions involving investments in fixed assets
and securities.

54
 Cont..d
The auditors assessment of control risk is an
iterative/doing again and again process that is
reined as the auditors obtain more and more
evidence about the effectiveness of various internal
controls polices and procedures. It may be
summarized as the following steps:
Determine the planned assessed level of
control risk,
Design and perform additional test of controls
Reassess control risk and modify planned
substantive tests
Document the assessed level of control risk
55