CHAPTER ONE

AN OVERVIEW OF AUDITING
Introduction

Reliable information is necessary if managers, investors, creditors, and regulatory agencies are to
make informed decisions about recourse allocation. Auditing play an important role in the
process by providing objective and independent reports on the reliability of information.

Auditing is important to both private and public enterprise. By adding the audit function to each
situation, the users of the financial statements have reasonable assurance that the financial
statements do not contain material misstatements or omissions.

Our purpose in this unit is to make clear the need of independent audits and the auditing
profession.

DEFINITION OF AUDITING.

Over the years, a variety of organizations and individuals have defined the broad form
"auditing". For example, the American Accounting Associations Committee on Basic Auditing
concepts developed a definition of auditing as follows:

Auditing is systematic process of objectively / factually obtaining and evaluating evidence

regarding assertions about economic actions and events to ascertain the degree of
correspondence between those assertions & established criteria and communicating the results
to interested users.
A systematic process:-connotes a logical, structured& organized series of steps or procedures.
Thus auditing proceeds by means of an ordered and structured series of steps.
Objectively obtaining and evaluating evidence: - means examining the bases for the assertions
and judiciously evaluating the result without bias or prejudice either for or against the individual
or(entity)making the assertion.
Assertions about economic actions and events:-are the representation made by the entity or
individual. They comprise the subject matter of auditing. Assertion includes information
contained in financial statements, internal operating reports and tax returns.
Degree of correspondence refers to the closeness with which the assertions can be identified
with established criteria. The expression of correspondence may be quantified, such as the

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 amount of a shortage in a petty cash fund, or it may be qualitative, such as the fairness of
financial statement.
Information and Established Criteria: -are the standards against which the assertions or representations
are judged. To do an audit, there must be information in a verifiable form and some standards (criteria) by
which the auditor can evaluate the information. Criteria may be specific rules prescribed by a legislative
body, budget & other measures of performance set by management, or GAAP established by, for
instance, FASB, IFRS &other authoritative bodies.

Communicating the results: - is achieved through a written report that indicated the degree of
correspondence b/n the assertions and established criteria. The communication of results either
enhances or weakens the credibility of the representations made by another party. The goal of
the audit process is to add credibility to management’s representations. So, that interested users
can use the information with reasonable assurance that it is free of material misstatements.
Interested users: - individuals who use (rely on) the auditor’s findings. In a business
environment, they include stockholders, management, creditors, government agencies and the
public.
Evidence is any information used by the auditor to determine whether the information being
audited is stated in accordance with the established criteria.
The International Federation of Accountants (IFAC) defines an audit as:

An audit is a work performed by an auditor to enable him/her to express an opinion whether the
financial statements are prepared, in all material respects, in accordance with an identified
financial reporting framework.
As the above definition shows an audit does not certify or guarantee that the financial statements
are correct or not; it only gives a reasonable assurance that the financial statements are free from
material misstatements. An audit may fail to detect over material misstatements because of
the following reasons.

i) An audit is based on a sample. Therefore, the evidence collected is persuasive rather than
conclusive
ii) Internal control systems that auditors rely on to perform their work have their own
limitations.

Evolution of Auditing

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It was recognized many years ago that whenever a fiduciary relationship with financial
implications existed there was a need for an outsider with sufficient independence and
objectivity to review the accounts of stewardship and to express an opinion as to their honesty or
otherwise. Modern auditing has developed since the concept of a company as a separate legal
entity came into existence. This led to the separation of ownership from management and a
consequent need to safeguard the interests of the owners (the shareholders), who in all but the
smallest of businesses (where shareholders and directors were one and the same) were not
involved in the day-to-day decisions made by the management. Directors must therefore be
accountable for their actions to the shareholders on a regular basis. This accountability mainly
occurs when the financial statements are formerly presented to shareholders.

Increasingly the services of professional accountants were being sought and employed in the
latter part of the nineteenth century and it was then that several professional accountancy bodies
were formed.

Some of the major auditing developments of the 20th century include:

1. A shift in emphasis to the determination of fairness in financial statements.

2. Increased responsibility of the auditor to third parties, such as governmental agencies,
stock exchanges, and an investing public numbered in millions.
3. A change in auditing methods from detailed examination of individual transactions to use
of sampling techniques, including statistical sampling.
4. Recognition of the need to consider the effectiveness of internal control as a guide to the
direction and amount of testing and sampling to be performed.
5. Development of new auditing procedures applicable to electronic data processing
systems, and use of the computer as an auditing tool.
6. Recognition of the need for auditors to find means of protecting themselves from the
current wave of litigation.

The Demand for Auditing

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An important question a student might ask is "why do organizations request an audit?" The
answer to this question can be found in the economic relationships that exist within an
organization, and between the organization and other parties that have a vested interest in the
organization. Among the reasons the majors are the following.

a) Control Mechanism
Audits whether internally or externally performed are valued as important control mechanisms
for accountability the overall need for monitoring activities, especially financial activity includes
the need for auditing to provide credibility for reported and unreported information.

b) Conflict of Interest
The agency relationship that exists between an owner and manager produces a natural conflict of
interest because of the information asymmetry that exists between the manager and the absentee
owner. Information asymmetry means that the manager generally has more information about the
"true" financial position and results of operations of the entity than the absentee owner does. If
both parties seek to maximize their own self-interest, it is likely that the manager will not act in
the best interest of the owner.

Whenever there is a conflict of interest between parties, the need for an arbiter or a non-partisan
view is obvious. In financial affairs there are natural grounds for conflict of interest between
information preparer and user, which can result in the production of a biased information data.
Thus an audit is required for an objective review of the information.

c) Consequences
The ultimate objective and function of accounting is to provide information for economic
decision-making. Information is used for decisions that have serious and substantial economic
consequences. Thus the need for an audit for verifying the accuracy of information before they
are used in decisions that may bring damaging consequences.

d) Remoteness

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Because of the separateness of the management from the owners; information is prepared in a
place far from the user. The user is prevented from directly assessing the quality of information
he obtains. Thus the need for auditor services to assess the information on the users' behalf.

e) Regulatory Requirements
Many business laws, memorandum of association and regulatory agencies acts make audits
annual requirements to be complied with for renewal of license or permit. For example the
security exchange commission (SEC) in the US; the Commercial Code of Ethiopia (1966), and
latter the Public Financial Regulation of Procl 163/1999 in Ethiopia make the filing of audited
financial statements annually. Disaster Prevention and Preparedness Commission (DPPC)
requires NGOs to prepare and submit their annual financial statements. Thus compliance
requirements create a very large demand for auditing services.

Accounting VS Auditing

Many financial statement users and members of the general public confuse auditing with
accounting. The confusion results because most auditing is concerned with accounting
information, and many auditors have considerable expertise in accounting matters. The
confusion is increased by the fact that auditing is performed by individuals described as public
accountants.

Accounting is the process of recording, classifying and summarizing economic events in a

logical manner for the purpose of providing financial information for decision-making
accounting is constructive. It starts with the raw financial data to process and produce financial
summary through reports known as financial statements as the end product of its work. The
function of accounting, to an entity and to society as a whole, is to provide certain quantitative
information that management and others can use to make decisions. To provide relevant
information, accountants need to have a thorough understanding of the rules and principles and
provide the basis for preparing the accounting information.

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Auditing on the other hand is analytical work that starts with the end product of accounting to
lend credibility and fairness of the measurements. In auditing, the concern is with determining
whether recorded information properly reflects the economic events that occurred during the
accounting period. Since the accounting rules and principles are the criteria for evaluating
whether the accounting information is properly recorded, any auditor involved with this data
must also thoroughly understand the accounting rules and principles. In the context of the audit
of financial statements these are generally accepted accounting principles (GAAP).

In addition to understanding accounting, the auditor must also possess expertise knowledge in
the accumulation and interpretation of audit evidence. Determining the proper audit procedures,
sample size, particular items to examine, timing of the tests, and evaluating the results are unique
to the auditor. It is these expertise that distinguishes auditors from accountants.

Types of Audits

While there are many types of audits based on the definitions previously provided, generally they
are discussed under three types:

i) financial statement audit

ii) compliance audits, and
iii) operational audit

i) Financial Statement Audit

The audit of financial statements ordinarily covers the balance sheet and the related statements of
income, retained earnings, and cash flows. The goal is to determine whether these statements
have been prepared in conformity with specified criteria.

Normally, the criteria are generally accepted accounting principles (GAAP), although it is
possible to conduct audits of financial statements prepared using some other basis of accounting
appropriate for the organization. Financial statement audits are normally performed by firms of
certified public accountants. Users of auditors' reports include management, investors, bankers,
creditors, financial analysts, and government agencies.

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ii) Compliance Audits

The purpose of compliance audit is dependent upon the existence of verifiable data and of
recognized criteria or standards, such as established laws and regulations, and or an
organization's policies and procedures. For example, the audit of an income tax returns by an
auditor of the Inland Revenue service. Such audits seek to determine whether a tax return is in

compliance with tax laws and Inland Revenue regulations. Determine whether accounting
personnel are following the procedures pre- scribed by the company controller. Review wage
rates for compliance with minimum wage laws. Examine contractual agreements with bankers
and other lenders to be sure the company is complying with legal requirements.

Like an independent financial statement audits, a compliance audit is designed to determine

whether an entity's financial statements are presented fairly in accordance with generally
accepted accounting principles. However, unlike a financial statement audit, a compliance audit
is also designed to determine whether the entity has complied with applicable laws and
regulations – hence the term "compliance" audits – that may have a material effect on financial
statements. Compliance audits are conducted by either independent auditors or government
auditors.

iii) Operational Audits

An operational audit involves a systematic review of an organization's activities, or a part of

them, in relation to the efficient and effective use of resources. The operations of the receiving
department of a manufacturing company, for example, may be evaluated in terms of its
effectiveness, that is, its success in meeting its stated goals and responsibilities. Performance is
also judged in terms of efficiency, that is, success using to its best advantage the resources
available to the department.

The purpose of an operational audit is to assess performance, identify areas of improvement, and
develop recommendations. Sometimes this type of audit is referred to as a performance audit or
management audit. Because the criteria for effectiveness and efficiency are not as clearly
established as are generally accepted accounting principles and many laws and regulations, an

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operational audit tends to require more subjective judgment than do audits of financial
statements or compliance audits. For example, quantifiable criteria often must be developed by
the auditors to be used to measure the effectiveness and efficiency of the department.

Comprehensive Audit
A comprehensive audit encompasses the determination of (1) the fair presentation of financial
statements, (2) the compliance with legislative or relative authorities, and (3) due regard for the
economy and efficiency in the administration of resources and the effectiveness of programs
(commonly known as value-for-money). Since the audit for the fair presentation of financial
statements has been discussed earlier, we shall focus our attention on the value-for-money aspect
of the comprehensive audit. The objective of a value-for-money audit is to assess management's
accountability for the economy and efficiency of the entrusted resources and the achievement of
objectives (effectiveness). Economy measures the relationship between resources acquired and
their costs. Thus, economy is achieved when the appropriate resources are acquired at the lowest
possible cost. Efficiency reflects the relationship between inputs and outputs.

It is considered efficient when a maximum amount of output is produced from a given input or a
minimum amount of input yields a maximum amount of output. Effectiveness refers to the
accomplishment of a set of goal or objective. Therefore, the degree of effectiveness is judged by
the extent to which the goal is achieved.

1.6. Types of Auditors

There are a number of different types of auditors; however, they can be classified under three
headings. Internal auditors, external auditors and government auditors. Each type of auditor will
be discussed briefly. One important requirement of each type of auditor is independence, in some
manner form the entity being audited.

a) Internal Auditors
Nearly every large organization maintains an internal auditing staff. A principal goal of the
internal auditors is to investigate and evaluate the effectiveness with which the various

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organizational units of the company are carrying out their assigned functions. Much attention is
given by internal auditors to the study and appraisal of internal control.

The institute of Internal Auditors (IIA) has developed a set of standards that should be followed
by internal auditors and has established a certification program. An individual meeting the
certification requirements set by the IIA, which includes passing a uniform written examination,
can become a certified internal auditor (CIA).

Like external auditors, internal auditors must be objective and independent. To help ensure the
objectivity and independence of internal auditors, the IIA suggests that the director of internal
auditing report directly to either the board of directors or the audit committee of the board or
have free access to the board. Regardless of their reporting level, however, internal auditors are
not independent in the same sense as external (independent) auditors. The internal auditors are
employees of the company in which they work, subject to the restraints inherent in the employer
– employee relationship.

Internal auditors can be involved in all three types of auditors. Their primary activities are to
conduct compliance and operational audits within their organization. However, they may also
assist the external auditors with the annual financial statement audit. Unlike the external auditors,
who are committed to verify cash significant item in the annual financial statements, the internal
auditors are not obliged to repeat their audits on an annual basis.

b) External Auditors
External auditors are often referred to as independent auditors or certified public accountants.
Such auditors are called "external" because they are not employed by the organization being
audited. An external auditor conducts financial statement audits for publicly traded and private
companies, partnerships, municipalities, individuals and other types of entities. They may also
conduct compliance and operational audits for such entities. An external auditor may practice as
a sole proprietor or as a member of a CPA firm.

The CPA certificate is regulated by state law through licensing department in each country. The
requirements for becoming a certified public accountant vary among countries. In our country
the General Auditors grants the license to work as an independent auditor when someone has the
certificate of certified public accountant through passing the qualification exams given in US

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(CPA) or UK (ACCA). In addition to these qualification exams the individual should possess at
least three-year experience in audit.

Professional standards require that external auditors maintain their objectivity and independence
when providing auditing or other attestation services for clients.

Government Auditors

The Government of Ethiopia has an auditor general the various regional governments are
expected to have Auditor Generals who are responsible for auditing the agencies who report to
that government. These government auditors may be appointed by committee or by the
government or party in power in jurisdiction. They report to their respective legislatures and are
responsible to the body appointing them. The primary responsibility of the government audit
staff is to perform the audit function for government. The extent and scope of the audits
performed are determined by legislation in the various jurisdictions.

For example, in 1977, the Federal Parliament made a revision to existing legislation in passing
the Auditor General Act which required the Auditor General to report to the House of Commons
on the efficiency and economy of expenditures or whether value-for-money had been received.

END OF CH 1
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