INSTITUTE OF ACCOUNTANCY ARUSHA

PRINCIPLES OF AUDITING (AFU 07305)

TOPIC ONE

1. NATURE, PURPOSE AND SCOPE OF AUDIT

INTRODUCTION
Economic decisions in every society must be based upon the information available at the time
the decision is made. For example, the decision of a bank to make a loan to a business is based
upon previous financial relationships with that business, the financial condition of the company
as reflected by its financial statements and other factors. If decisions are to be consistent with
the intention of the decision makers, the information used in the decision process must be
reliable. Unreliable information can cause inefficient use of resources to the detriment of the
society and to the decision makers themselves. As society become more complex, there is an
increased likelihood that unreliable information will be provided to decision makers. There are
several reasons for this: remoteness of information, voluminous data and the existence of
complex exchange transactions. As a means of overcoming the problem of unreliable
information, the decision-maker must develop a method of assuring him that the information
is sufficiently reliable for these decisions. In doing this he must weigh the cost of obtaining
more reliable information against the expected benefits. A common way to obtain such reliable
information is to have some type of verification (audit) performed by independent persons. The
audited information is then used in the decision-making process on the assumption that it is
reasonably complete, accurate and unbiased.

1.1 Meaning and evolution of Auditing

Meaning of Auditing
There are various definitions of auditing these include
• Auditing is such an examination of books of accounts and vouchers of business, as will
enable the auditors to satisfy himself 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 that the profit and
loss account gives true and fair view of the profit/loss for the financial period, according
to the best of information and explanation given to him and as shown by the books; and
if not, in what respect he is not satisfied."
• Auditing is an examination of accounting records undertaken with a view to establish
whether they correctly and completely reflect the transactions to which they relate.

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 • Audit is an instrument of financial control. It acts as a safeguard on behalf of the
proprietor (whether an individual or group of persons) against extravagance,
carelessness or fraud on the part of the proprietor's agents or servants in the realization
and utilization of the money or other assets and i1t ensures on the proprietor's behalf
that the accounts maintained truly represent facts and that the expenditure has been
incurred with due regularity and propriety. The agency employed for this purpose is
called an auditor."

Evolution of Auditing
The word “audit” comes from the Latin word audire which means “to hear” because, in the
middle Ages, accounts or revenue and expenditure were “heard” by the auditor. An auditor
used to listen to the accounts read over by an accountant in order to check them. Auditing is
as old as accounting. It was in use in all ancient countries such as Mesopotamia, Greece, Egypt.
Rome, U.K. and India.

The original objective of auditing was to detect and prevent errors and frauds. Auditing evolved
and grew rapidly after the industrial revolution in 18th century with the growth of the joint stock
companies the ownership and management became separate. The shareholders who were the
owners needed a report from an independent expert on the accounts of the company managed
by the board of directors who were the employees. The objective of audit shifted, and audit
was expected to ascertain whether the accounts were true and fair rather than detection of errors
and frauds.

With the increase in the size of the companies and the volume of transactions the main objective
of audit shifted to ascertaining whether the accounts were true and fair rather than true and
correct. Hence the emphasis was not on arithmetical accuracy but on a fair representation of
the financial efforts. Today most counties have made auditing a statutory request for public
companies and has a board that has set standards and regulations that guide the daily work of
auditors(NBAA in Tanzania). The latest developments in auditing pertain to the use of
computers in accounting and auditing.
In conclusion it can be said that auditing has come a long way from hearing of accounts to
taking the help of computers to examine computerized accounts.

1.2 Audit and concepts of accountability and stewardship

Accountability,
Auditors act in the interest of the primary stakeholders whilst having regard to the wider public
interest. The identity of the primary stakeholders in determined by reference to the statute of
agreement requiring an audit. For companies, the primary stakeholder is the general body of
shareholders, creditors, debtors, employees etc.
Stewardship
Directors or other managers of an enterprise have the responsibility of stewardship (employed
to supervise, collect income and keep accounts) for the property of that enterprise.
Responsibilities, which may be duties embodied in statute, may include: Keeping books of
accounts and proper accounting records; Producing a balance sheet and income statement that
show a true and fair view; Producing a directors’ report which is consistent with the financial
statements and contains certain specified information.

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 1.3 Audit and agency
A director can be described as an agent having a fiduciary relationship with a principal (i.e.
the company that employs him). (A fiduciary relationship is one of trust.)In meeting their
responsibilities of stewardship, managers have fiduciary duties to safeguard assets and
implement and operate an adequate accounting and internal control system.

1.4 Forms of Audit

There are various forms of Audit but the main forms are the external and internal audit

A. Internal audit
Refers to an organization auditing its own systems, a self-assessment used to measure the
strengths and weaknesses against requirements, and an organizations own standards. An
internal auditor can become a type of internal consultant for the organization
The purpose of the internal auditing activity is to provide an independent, objective assurance
and consulting services designed to add value and improve the organization’s operations.
The scope of work of the internal audit is to determine whether the organization’s network of
risk management, control, and governance processes, as designed and represented by
management, is adequate and functioning in a manner to ensure amongst others that:
• Risks are appropriately identified and managed;
• Significant financial, managerial, and operating information is accurate, reliable, and timely;
• Resources are acquired economically, used efficiently, and adequately protected and
• Programs, plans, and objectives are achieved.
Opportunities for improving management control, service delivery, and the organization’s
image may be identified during audits and, communicated to the appropriate level of
management.
Reasons to perform
Ø Value added to Management -What value will it achieve for the company?
Ø Conformance to Internal Procedures-Often a visual of a task or a review of
documentation
Ø Compliance to Regulations/Standards-check the box type of monitoring or
documentation audit
Ø Effectiveness of Corrective Actions-monitor, measure and analyze Good business
practice and they make sense They are meant to detect problems early
Internal audit may be performed by trained staff not directly responsible for what is being
audited or an outside Consultant if no one else is available

B. External audit
An external audit is a review of the financial statements or reports of an entity, usually a
government or business, by someone not affiliated with the company or agency. External audits
play a major role in the financial oversight of businesses and governments because they are
conducted by outside individuals and therefore provide an unbiased opinion. External audits
are commonly performed at regular intervals by businesses, and are typically required yearly
by law for governments.
One organization auditing another with which it either has, or is going to have, a contract or
agreement for the supply of goods or services Supplier audit will include the Quality
Management System involved in the items or service provided

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Other forms of audit include

I. Management audit
A systematic assessment of methods and policies of an organization's management in the
administration and the use of resources, tactical and strategic planning, and employee and
organizational improvement.
The objectives of a management audit are to
(1) establish the current level of effectiveness,
(2) suggest improvements,
(3) laydown standards for future performance. Management auditors (employees of the
company or independent consultants) do not appraise individual performance, but may
critically evaluate the senior executives as a management team. Can also be known as
performance audit.

II. Value for money audit

This is an Independent audit of a not-for-profit organization (government agency or unit,
charity, trust, etc.) to assess the effectiveness and efficiency of its utilization of funds. It is
employed where the standard commercial performance (profit oriented) measures cannot be
used. Also called value for money analysis.

III. Regulatory audit

Audit undertaken to confirm whether a firm is following the terms of an agreement (such as a
bond indenture), or the rules and regulations applicable to an activity or practice prescribed by
an external agency or authority.
Regulatory audits include but are not limited to financial statements audit. A major role of the
auditor is to participate in the prudential supervision exercised by the regulatory bodies.
Additional involvement may also be requested to answer specific needs.

IV. Environmental audit

Environmental audits are reviews of a company's operations and processes to determine
compliance with environmental regulations. Audits cover buildings and building sites;
activities and procedures; industrial and commercial developments; and engineering hazard
and operability studies.
Environmental audits can be costly—but, conversely, failure to carry out such audits can have
much more expensive, and sometimes prohibitively expensive, consequences. They are
undertaken, for these reasons, when mandated by law or prudence. Two major types of audits
are conducted: 1) site inspection related to buying and selling land and 2) operational audits
carried out either voluntarily in order to avoid or reduce penalties or because they are mandated
under law.

1.5 Objectives of Auditing

There are two main objectives of auditing the primary objective and the secondary or incidental
objective.
a. Primary objective – the primary duty (objective) of the auditor is to report to the owners
whether the balance sheet gives a true and fair view of the Company’s state of affairs and the
profit and loss A/c gives a correct figure of profit of loss for the financial year.
b. Secondary objective – it is also called the incidental objective as it is incidental to the
satisfaction of the main objective. The incidental objective of auditing are:
i. Detection and prevention of Frauds, and
ii. Detection and prevention of Errors.

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Detection of material frauds and errors as an incidental objective of independent financial
auditing flows from the main objective of determining whether or not the financial statements
give a true and fair view. As the Statement on auditing Practices issued by the Institute of
Chartered Accountants of India states, an auditor should bear in mind the possibility of the
existence of frauds or errors in the accounts under audit since they may cause the financial
position to be mis-stated.
Fraud refers to intentional misrepresentation of financial information with the intention to
deceive. Frauds can take place in the form of manipulation of accounts, misappropriation of
cash and misappropriation of goods. It is of great importance for the auditor to detect any
frauds, and prevent their recurrence. Errors refer to unintentional mistake in the financial
information arising on account of ignorance of accounting principles i.e. principle errors, or
error arising out of negligence of accounting staff i.e. Clerical errors.

1.6 Main Principles and concepts in auditing

Ø Materiality
Materiality is a concept or convention within auditing and accounting relating to the
importance/significance of an amount, transaction, or discrepancy. The objective of an audit of
financial statements is to enable the auditor to express an opinion whether the financial
statements are prepared, in all material respects, in conformity with an identified financial
reporting framework such as Generally Accepted Accounting Principles (GAAP). The
assessment of what is material is a matter of professional judgment. Materiality is in both the
amount (quantity) and nature (quality) of misstatements are relevant to deciding what is
material.

"Information is material if its omission or misstatement could influence the economic decision
of users taken on the basis of the financial statements. Materiality depends on the size of the
item or error judged in the particular circumstances of its omission or misstatement. Thus,
materiality provides a threshold or cut-off point rather than being a primary qualitative
characteristic which information must have if it is to be useful."
The Financial Accounting Standards Board (FASB) has refrained from giving quantitative
guidelines for determining materiality. This has resulted in confusion in the use of Auditing
Standards No 47, "Audit Risk and Materiality in Conducting the Audit". Several common rules
that have appeared in practice and academia to quantify materiality include:
Percentage of gross profit; Percentage of total assets; (i.e.,1/3% of total assets); Percentage of
total revenue; (1/2% of total revenues); Percentage of equity; (i.e.,1% of total equity);

How materiality apply in an audit

The objective of a financial statement audit is to enable the auditor to express an opinion as to
whether the financial statements are prepared, in all material respects, in accordance with an
applicable financial reporting framework. This is a separate responsibility and a separate
decision from that made by the entity itself when preparing the financial statements.
In auditing, materiality means not just a quantified amount, but the effect that amount will
have in various contexts.

During the audit planning process, the auditor decides what the level of materiality will be,
taking into account the entirety of the financial statements to be audited. Materiality relates to
both the content of the financial statements and the level and type of testing to be done. The
decision is based on judgments about the size, nature and particular circumstances of

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misstatements (or omissions) that could influence users of the financial reports. In addition, the
decision is influenced by legislative and regulatory requirements and public expectations.
If, during the audit, the auditor acquires information that would have caused it to determine a
different materiality level, it will revise the materiality level accordingly.

Ø True and fair

True and fair view in auditing means that the financial statements are free from material
misstatements and faithfully represent the financial performance and position of the entity.
Although the expression of true and fair view is not strictly defined in the accounting literature,
we may derive the following general conclusions as to its meaning: True suggests that the
financial statements are factually correct and have been prepared according to applicable
reporting framework such as the IFRS and they do not contain any material misstatements that
may mislead the users. Misstatements may result from material errors or omissions of
transactions & balances in the financial statements.
Fair implies that the financial statements present the information faithfully without any element
of bias and they reflect the economic substance of transactions rather than just their legal form.

Application & Importance

Preparation of true and fair financial statements has been expressly recognized as one of the
responsibilities of the directors of companies in the corporate law Tanzania. Auditors must
therefore consider whether directors have fulfilled their responsibility for the preparation of
true and fair financial statements when providing an audit opinion.
Company law require the auditors to expressly state in their audit report whether in their
opinion the financial statements present a true and fair view of the financial performance and
position of the entity.

Ø Presentation and disclosure

For an auditor to establish that financial records have been presented and all information
accurately disclosed they should look at,
§ Occurrence — the transactions and disclosures have actually occurred.
§ Rights and Obligations — the transactions and disclosures pertain to the entity.
§ Completeness — all disclosures have been included in the financial statements.
§ Classification — financial statements are clear and appropriately presented.
§ Accuracy and Valuation — information is disclosed at the appropriate amounts.

Ø Reasonable assurance
Reasonable assurance’ is the level of confidence that the financial statements are not
materially misstated that an auditor, exercising professional skill and care, is expected to attain
from an audit.

An auditor cannot attain absolute confidence because of numerous factors arising,

among other things, from the limitations of audit evidence, the impracticality of examining all
evidence and uncertainties as to the future.

The confidence that an auditor attains is subjective and is the basis for offering an audit
opinion. Users of financial statements derive their own confidence in the audited financial
statements from many sources, including a knowledge that the auditors work to professional

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standards within a framework of regulation and that the auditors have felt sufficiently confident
that the financial statements are not materially misstated to issue an opinion.

As a consequence of their confidence that financial statements are not materially

misstated, users of financial statements may also gain confidence that the management of the
entity are conducting its affairs in the knowledge that the financial consequences of their
actions will be reported.

The Auditor’s Process

Where it is management’s responsibility to prepare the financial statements, it is the
auditor’s job to verify whether the financial statements are true and fair. Put differently, it is
the auditor’s job to validate management’s assertions. In order to do so, the auditor will identify
audit objectives, which can be regarded as the auditor’s counterpart of management assertions.
The auditor will define audit objectives for existence of sales, completeness of expenses,
presentation and disclosure (based on IFRS) and valuation and rights and obligations of
inventory. The auditor will develop these specific audit objectives for which they must test for
evidence as proof.

After the identification of accounts, classes of transactions and the related management
assertions and audit objectives, the auditor will determine the nature, amount and timing of the
audit procedures to be carried out. In order to do so, he will perform risk analysis for each audit
objective, i.e. he will determine the susceptibility of account balances and transactions to
misstatement.

Further, the auditor will have to determine the exactness with which he will perform
his audit. It is reasonable to suppose that the auditor will accept a greater tolerance in the audit
of a large, multinational enterprise than in the audit of a small, local company. This raises the
issue of materiality and of tolerable errors in the audit process. In designing an audit program
for a specific account, the auditor starts by developing general objectives from the financial
statement assertions of management. Then, specific objectives are developed for each account
under audit, and finally, audit procedures are designed to accomplish each specific audit
objective.

READING ASSINGMENT

Read on the following concepts

• Management assertion
• Audit Risk