Introduction to Audit

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Origin and History of Audit:

The word audit is derived from the Latin word 'audire' which means 'to hear'. The origin of
audit can be traced back to very old times but the concept of modern auditing sprung up in the
middle of the 19th century. In older times, methods of accounting were very simple and the
number of transactions was so small that every individual was in a position to check all the
transactions recorded. Whenever the owner of the business suspected fraud, he appointed an
official to check the accounts. The person appointed by the employer to examine the accounts
came to be known as the 'auditor'. In older times, the aim of audit was to check accounting of
cash primarily. The objective was to find out whether cash had been embezzled, and if so, who
did it and what was the amount involved. Thus, it was only an audit of the cash book. In present
times, the main aim of audit is to find out whether the financial statements represent a ‘true
and fair’ view.

Introduction to Audit

In a public limited company the division between ownership and control needs to be
understood. Shareholders, own the company while the directors, manage the company.
Shareholders appoint directors to look over the company on their behalf, and the legislation
requires directors to prepare financial statements to be presentable to the shareholders. This
division between ownership and control of the company requires a third independent party to
give their opinion on the financial statements to add credibility to the whole process.

Definition of Audit:
External audit is defined as ‘the independent examination and expression of opinion on the
true and fair view of the financial statements of a company by an independent third party
known as the external auditor’.

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Need for Audit:
The problem that has always existed when the director’s report to the shareholders through
financial statements has been the credibility of the financial statements. The financial
statements being issued may:

• Contain errors
• Not disclose fraud
• Fail to disclose relevant information
• Fail to follow laws
• Be misleading

The solution to these problems of credibility in reports and accounts lies in appointing, an
independent person called an auditor, to investigate the reports and submit his findings.

Objective of an Audit
The primary objective of an audit of financial statements is to enable the auditor to express an
opinion on the financial statements of the company. In addition the audit serves the following
objectives:
• Fulfilment of the statutory requirements.
• Increase in the credibility of the financial statements.
• Increase the confidence of the stakeholders in the financial statements.

Role of External Auditor:

The primary role of an external auditor is to report on the truth and fairness of the financial
statements of a company on behalf of its owners.

An external audit is a legal requirement for public limited companies, although many smaller
entities are exempt from it. The financial statements have to be examined by an independent
expert, the auditor, who is required to give an opinion on their truth and fairness. The
shareholders have limited access to information about the operations of the company. They
may lack trust in the directors and may believe that the information in the financial statements
is biased. Under law, the external auditor reports to, and are, appointed by the shareholders.

Communication of opinion by the Auditors:

Once the external auditors have performed audit they present their opinion on the financial
statements. The report issued after a statutory audit is addressed to the shareholders. A
statutory audit report will necessarily contain the following sections:
• Heading (Audit report for Company name)
• Appropriate Addressee (Addressed to the shareholders/members.)

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• Introductory Paragraph. (We have audited the financial statements.)
• Management’s responsibility of the financial statements (It is management
responsibility to prepare F/S according to standards and keep proper accounting
records)
• Auditor’s responsibility of the financial statements (It is our duty to express opinion on
the F/S.
• Opinion on the financial statements.
• Auditor’s signature, date of the audit report and the address of the audit report.

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 Essential Audit Terms

True and Fair View:

There is no strict definition in the accounting or auditing literature for 'true and fair' view but
the following perception is taken for its understanding. Financial statements are considered to
be 'true and fair' when:
• Have been prepared in accordance with the accounting/financial reporting standards.
• Proper accounting records have been kept which were essential for the preparation of
the financial statements.
• Financial statements are free from material misstatements.
• The financial statements present information faithfully without any element of bias.

Reasonable Assurance:
The opinion given by the external auditor on the financial reports is of ‘reasonable assurance’.
No auditor can give 100% assurance. The highest level of assurance given, as in the case of
statutory audit, is described as 'reasonable assurance'. 'Reasonable assurance' is less than
absolute assurance. Reasonable assurance is achieved after:
• The use of selective testing.
• It is based on the application of 'sampling'.

Materiality:
The objective of an audit of financial statements is to enable the auditor to express an opinion
on whether the financial statements are prepared in all material respects, with an identified
financial reporting framework. Thus materiality is defined as:
• Information is material if its omission or misstatement could influence the economic
decisions of users taken on the basis of the financial statements.
• The auditor must be concerned with identifying 'material' errors, omissions and
misstatements.
• To put this into practice the auditor therefore has to set his own materiality levels –this
will always be a matter of judgment.

Auditor Rights and Duties:

To perform their duty with effectiveness the external auditors have been bestowed some
rights. The rights and duties of the external auditors are:

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Auditors Right Auditors Duties
Access to books and records of the Report and give opinion on the ‘true and fair’
company. view of financial statements.
Access to information and explanation. Report on the proper preparation of accounts.
Receive notice to attend general meetings. Report on information and explanations
received.
Right to speak at general meetings.

Types of Audits

External Audit
External audit is conducted by an independent external auditor. It is conducted as a
requirement of law. Qualified chartered accountants having no connection to the company can
act as external auditors of a company. Conducted on a yearly basis, the purpose of this audit is
to see whether financial statements present a 'true and fair' view. The external audit is
primarily conducted to add credibility to the financial statements so that the bridge created due
to division of ownership and control could be managed.

Final Audit
Final audit is the audit which is taken up at the close of the financial year when all the accounts
have been closed and the final accounts have been prepared.

Interim Audit
Interim audit is the audit which is conducted in between the two annual audits with a view to
find out the interim profit of the business to enable it to declare an interim dividend.

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