SOUTH EASTERN UNIVERSITY OF SRI LANKA

FACULTY OF MANAGEMENT AND COMMERCE

DEPARTMENT OF ACCOUNTANCY AND FINANCE

Introduction to Auditing
Bachelor of Business Administration Third Year, Semester-I

Lecturer in Charge: A L Sarifudeen

B.Com (Hons) Spl, in Acc & Fin. Mgt (SEUSL) , MBA (WUSL) , MAAT (SL)
ACPM (SL), CTHE (CMB), SEDA (UK)

Meaning of Audit:

The word audit is derived from the Latin word “AUDIRE” which means to hear. Initially
auditor was a person appointed by the owners to check account whenever the suspected fraud,
he was to hear explanation given by the person responsible for financial transactions.
Emergence of joint stock companies changed the approach of auditing as ownership was
pestered from management. The emphasis now is clearly on the verification of accounting date
with a view on the reliability of accounting statement.

Definition:
Spicer and Peglar define auditing as “An examination of the books, accounts and vouchers of
a business’s shall enable the auditor to satisfy himself whether or not the balance sheet is
properly drawn up so as to exhibit a true and correct view of the state of affairs of the business
according to his best of the information given to him and as shown by the book.
Mautz: defines auditing as being “Concerned with the verification of accounting data with
determining the accuracy and reliability of accounting statements and reports.”

The international auditing practices committee defines auditing as “the independent

examination of financial information of any entity whether profit oriented or not and
irrespective of size/legal form when such an examination is conducted with a view to express
an opinion thereon”.

What is an Audit?

Audit is an independent examination of financial statements of an entity that enables an auditor

to express an opinion whether the financial statements are prepared (in all material respects) in
accordance with an identified and acceptable financial reporting framework (e.g. international
or local accounting standards and national legislations)

This view of audit is presented by SLAuS 200 Objective and General Principles Governing an
Audit of Financial Statements.

The phrases used; “to express the auditor’s opinion” means that the financial statements give a
true and fair view or have been presented fairly in all material respects.

True and fair presentation means that the financial statement are prepared and presented in
accordance with the requirements of the applicable International Financial Reporting Standards
(IFRS) and local pronouncements/legislations.

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What we can understand as the essential features of an audit from the above definition and
explanation are as under:

 An auditor involves in examination of financial statements, the auditor is not responsible

for the preparation of the financial statements.

 The end result of an audit is an opinion to assist the user of the financial statements.
Auditing therefore relies heavily on professional judgment, not merely on the facts.

 The auditor’s opinion makes reference to “true and fair” or “fair presentations” but “true
and fair “is again a matter of judgment. It is not precisely defined for the auditor.

 In order to make the user of the auditor’s report able to feel confident in relying on such
report, the auditor should be independent of the entity. Independent essentially means
that the auditor has no significant personal interest in the entity. This allows an
objective, professional view to be taken.

You will note that this is a wide concept of an audit which can be applied to any entity, not just
to limited companies. However, in this course, we are concerned primarily with audits of
limited companies (often known as statutory or external audits). Any other audit applications
will be clearly indicated for you in the text.

Why is there a need for an audit?

The problem that has always existed at the time when the manager reports to the owners is that:
whether the owners will believe the report or not? This is because the reports may:

a) Contain errors
b) Not disclose fraud
c) Be inadvertently misleading
d) Be deliberately misleading
e) Fail to disclose relevant information
f) Fail to conform to regulations

The solution to this problem of credibility in reports and accounts lies in appointing an
independent person called an auditor to examine the financial statements and report on his
findings.

A further point is that modern companies can be very large with multi-national activities. The
preparation of the accounts of such groups is a very complex operation involving the bringing
together and summarizing of accounts of subsidiaries with differing conventions, legal systems
and accounting and control systems. The examination of such accounts by independent experts
who are trained in the assessment of financial information is of benefit to those who control
and operate such organizations as well as to owners and outsiders.

Many financial statements must conform to statutory or other requirements. The most notable
is that all company accounts have to conform to the requirements of the Companies Act No.07
of 2007 but many other bodies (like: Charities, Building Societies, Financial Services business
etc) have detailed accounting requirements as required by the relevant legislations. In addition

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all accounts should conform to the requirements of International Financial Reporting Standards
(IFRSs).

It is essential that an audit of financial statements should be carried out to ensure that they
conform to these requirements.

Objectives of Auditing.
Auditors are basically concerned with verifying whether the account exhibit true and fair view
of the business. The objectives of auditing depends upon the purpose of his appointment.

Primary Objective.
The primary objective of an auditor is to respect to the owners of his business expressing his
opinion whether account exhibits true and fair view of the state of affairs of the business. It
should be remembered that in case of a company, he reports to the shareholders who are the
owners of the company and not tot the director. The auditor is also concerned with verifying
how far the accounting system is successful in correctly recording transactions. He had to see
whether accounts are prepared in accordance with recognized accounting policies and practices
and as per statutory requirements.

Secondary Objective:
The following objectives are incidental to the main objective of auditing.
1. Detection and prevention of errors: errors are mistakes committed unintentionally
because of ignorance, carelessness. Errors are of many types:
a. Errors of Omission: These are the errors which arise on account of transaction into
being recorded in the books of accounts either wholly partially. If a transaction has been
totally omitted it will not affect trial balance and hence it is more difficult to detect. On
the other hand if a transaction is partially recorded, the trial balance will not agree and
hence it can be easily detected.
b. Errors of Commission: When incorrect entries are made in the books of accounts
either wholly, partially such errors are known as errors of commission. Eg: wrong
entries, wrong Calculations, postings, carry forwards etc such errors can be located
while verifying.
c. Compensating Errors: when two/more mistakes are committed which counter
balances each other. Such an error is know an Compensating Error. Eg: if the amount
is wrongly debited by Rs 100 less and Wrongly Credited by Rs 100 such a mistake is
known as compensating error.
d. Error of Principle: These are the errors committed by not properly following the
accounting principles. These arise mainly due to the lack of knowledge of accounting.
Eg: Revenue expenditure may be treated as Capital Expenditure.
e. Clerical Errors; A clerical error is one which arises on account of ignorance,
carelessness, negligence etc.

What is the distinction between auditing and accounting?

Relationship between auditing and accounting

Auditing and accounting are closely connected but both are separate activities. The directors
of a company are responsible for establishing books of accounts that will accurately record
financial information and that are used for preparing the annual financial statements. It is
similarly the responsibility of the directors to adopt consistent and appropriate accounting

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policies in order to prepare and present the financial statements. The financial statements have
to comply with national legislative requirements and International Financial Reporting
Standards (IFRSs).

Accounting is the process of recording, classifying, summarizing and reporting financial

information in a logical/systematic manner for the purpose of decision making. To provide
relevant & reliable information, accountants must have a thorough understanding of the
principles and rules that provide the basis for preparing the financial statements.

In auditing the financial statements, the concern is with determining whether the presented
financial statements properly (true and fair) reflect the financial information that occurred
during the accounting period. Since auditors are primarily concerned with the end result of this
work i.e. do the financial statements show a true and fair view? In order to arrive at their
conclusion the auditors must have a deep knowledge and understanding of accounting
(including applicable accounting standards) and in practice, the directors will consult with the
auditors as to appropriate accounting policies to follow.

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 giving the title “Chartered Accountant” to individuals performing a
major portion of the audit function.

What are the advantages and disadvantages of auditing?

Advantages of an audit

We have seen that the need for an external audit in the case of companies arises primarily
from the existence of split-up of ownership from control. There are however, certain
advantages in having financial statements audited even where no statutory requirement exists
for such an audit in the case of a sole-tradership, partnership, or non-profit organizations for
example.

These advantages can be summarized as follows:

a) Disputes between management may be more easily settled. For instance, a partnership
which has complicated profit sharing arrangements may require an independent
examination of those accounts to ensure, as far as possible, an accurate assessment and
distribution of the profits.

b) Major changes in ownership may be facilitated if past accounts contain an independent

audit report, for instance, where two sole traders merge their business to form a new
partnership.

c) Application to lenders/financial institutions for finance may be strengthened by the

submission of audited accounts. However do remember that a bank, for instance, is
likely to be far more concerned about the future of the business and available security,
than by the past historical accounts, audited or otherwise.

d) The audit is likely to involve an in depth examination of the business and so may enable
the auditor to give more constrictive advice to management on improving the efficiency
of the business.

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Disadvantages of an audit

Like most thing in life, audits are not entirely without their disadvantages. There are two main
points to make here:

a) The audit fee! Clearly the services of an auditor must be paid for. It is for this reason
that few partnerships and even fewer sole traders are likely to have their accounts
audited.
b) The audit involves the client’s staff and management in giving time to providing
information to the auditor. Professional auditors should therefore plan their audit
carefully to minimize the disruption which their work will cause.

What are the different stages of audit?

Auditing is essentially a practical task. The auditor always needs to reflect the nature of the
circumstances of the entity under audit. It is unlikely that any two audit assignments will ever
identical. It is however possible to identify a number of standard stages in a typical external
audit. These are as follows:

 Audit appointment
 Engagement letter
 Initial planning
 Knowledge of the business
 Risk Assessment
 Internal control review (procedures)
 Control procedures (authorities/approvals/segregation of duties)
 Preparation of the audit plan
 Accounting system review
 Analytical review techniques (Compliance procedures-Application of control
test procedures) like purchasing are according to the controls established.
 Considering the ways in which audit evidence can be sought
 Substantive testing (transaction level procedures)
 Reasonable assurance
 Review of the financial statements (compliance with the standards/material
misstatement etc.)
 Preparation and signing of report

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International Standards on Auditing (ISAs)

The role of auditing standards

The role of the audit is to provide a high level of assurance to the users of the financial
statements. This assurance will be of greater value to users if they know that the audit has been
carried out in accordance with established standards of practice.

In addition, if users compare the financial statements of a number of companies, it is important

that the user has confidence that consistent auditing standards have been applied to the audits
of all of the companies.

International Standards on Auditing (known as ISAs) apply primarily to the external audit
process. However, their provisions can also often be seen as good practice for relevant areas of
the work of the internal auditor.

The process of issuing auditing standards

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 ICASL is a member of IFAC.

Producing a new ISA

The process of producing an ISA is as follows:

 A subject is selected for detailed study, with a view to eventually issuing an ISA.
 After a period of study and research, if there is agreement to proceed, an exposure
draft is produced. The exposure draft is approved by the IAASB and then distributed
widely amongst the profession and others for comment.
 Comments and proposed amendments are considered by the IAASB. The draft standard
is then modified and approved by the IAASB.
 The new ISA is then published.

International Auditing Practice Statements

In addition to ISAs, the IAASB also issues International Auditing Practice Statements
(IAPSs). These do not have the same authority as ISAs. IAPSs aim to:

 provide help to auditors in implementing ISAs

 promote good auditing practice in general.

Preface to International Standards on Quality Control, Auditing, Review, Other

Assurance and Related Services

The IAASB issues a number of other international standards, in addition to ISAs. The table
below sets out these standards, including ISAs, and when the preface says they are to be
applied.

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The IAASB’s pronouncements do not override local laws or regulations. If local laws or
regulations differ from, or conflict with, the IAASB’s standards then a professional accountant
should not state that he has complied with the IAASB’s standards unless he has fully complied
with all of those relevant to the engagement.

International Standards on Auditing (ISAs)

ISAs are written in the context of an audit of financial statements by an independent auditor.
They are to be adapted as necessary when applied to audits of other historical financial
statements.

Each ISA contains:

 an introduction
 objectives
 definitions (if necessary)
 requirements which are shown by the word “shall” and are to be applied as relevant to
the audit
 application and other explanatory material which is for guidance only.

International Standards on Quality Control (ISQCs)

ISQCs apply to all services carried out under the IAASB’s engagement standards (ISAs, ISREs,
ISAEs and ISRSs).

Other International Standards

The other international standards (ISREs, ISAEs and ISRSs) contain:

 basic principles and essential procedures (identified in bold type and by the word
“should”), and
 related guidance in the form of explanatory and other material, including appendices.

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The basic principles and procedures must be followed. In exceptional circumstances, a
professional accountant may judge it necessary not to follow a relevant essential procedure in
order to achieve their objectives. In these circumstances, the auditor must be prepared to justify
the departure from the requirements of the standard.

Professional judgment
The nature of the international standards requires the professional accountant to exercise
professional judgment in applying them.

Sri Lanka Accounting & Auditing Standards

The Sri Lanka Accounting and Auditing standards Act No. 15 of 1995 has empowered the
Institute of Chartered Accountants of Sri Lanka (CA Sri Lanka) to promulgate and adopt Sri
Lanka Accounting Standards and Sri Lanka Auditing Standards in the country. The
observances of the said standards are mandatory for Specified Business Enterprises (SBEs) in
Sri Lanka. The Act provides the establishment of "Accounting Standards Committee" and
"Auditing Standards Committee" for the purpose of assisting the Council of CA Sri Lanka in
the promulgation of these standards.

Sri Lanka has converged with the latest pronouncements issued by the IASB, IAASB and IFAC
and CA Sri Lanka is indeed proud to be the pioneer in introducing good financial reporting
practices in Sri Lanka.

The Sri Lanka Auditing Standards are based on the International Standards on Auditing (ISA)
published by the International Auditing Practices Committee (IAPC) of the International
Federation of Accountants (IFAC), with slight modifications to meet local conditions and
needs. Hence compliance with the Sri Lanka Auditing Standards ensures compliance in all
material respects with the International Standards on Auditing.

This the new bound volume comprises of the Sri Lanka Auditing Standards and Sri Lanka
Standards on Quality Control 1 (Volume I) and Sri Lanka Other Audit Pronouncements and
Sri Lanka Related Services Pronouncements (Volume II). Volume II can be referred under
Audit Pronouncements via CA Sri Lanka website. These Standards are very well compiled and
should provide excellent material for Audit Practitioners.

Under the Act, compliance with these Standards is compulsory when carrying out the audits of
entities specified in the said Act. This Act not only places the responsibility of complying with
these Standards on the Auditors alone, but also places a corresponding responsibility on the
entity's Management to take all reasonable steps to ensure that these Standards are complied
with in the conduct of the audits of their accounts.

As required by the Sri Lanka Accounting & Auditing Standards Act No. 15 of 1995, these
Standards have been reviewed by the Statutory Auditing Standards Committee set up under the
Act and recommended for adoption by the Council of the Institute. Accordingly the Council
has adopted these Standards as the Sri Lanka Auditing Standards (SLAuSs).

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Sri Lanka Auditing Standard 200

Objective and General Principles Governing an Audit of Financial Statements (SLAuS

200)

The purpose of this Sri Lanka Auditing Standard (SLAuS) is to establish standards and provide
guidance on the objective and general principles governing an audit of financial statements.

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 accordance with an
identified financial reporting framework. The phrases used to express the auditor’s opinion are
“give a true and fair view” or “present fairly, in all material respects,” which are equivalent
terms.

Applicable Financial Reporting Framework

The “applicable financial reporting framework” comprises those requirements of accounting

standards, law and regulations applicable to the entity that determine the form and content of
its financial statements.

Although the auditor’s opinion enhances the credibility of the financial statements, the user
cannot assume that the opinion is an assurance as to the future viability of the entity nor the
efficiency or effectiveness with which management has conducted the affairs of the entity.

General Principles of an Audit

Professional Ethics
There are a number of ethical matters that are extremely important for auditors to consider
when performing their work. It is vital to the public image and credibility of the profession that
the auditor is seen to be behaving in an acceptable manner in addition to actually complying
with the ethical requirements.

It is important to recognize that many groups in society rely on accountant’s work, not just
the shareholders on whose behalf the accountant is working. The accountant therefore has a
public accountability.

The auditor should comply with the Code of Ethics for Professional Accountants issued by the
Institute of Chartered Accountants of Sri Lanka. Ethical principles governing the auditor’s
professional responsibilities are:

a) Independence;
b) Integrity;
c) Objectivity;
d) Professional competence and due care;
e) Confidentiality;
f) Professional behavior; and
g) Technical standards.

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a) Independence: Auditor is independent of management i.e. he is not under the control or
influence of management.

b) Integrity: Auditor is honest and is not corrupt. He is straight forward in performing his
professional work.

c) Objectivity: He obtains the evidence needed to form an opinion and his opinion is based
on that evidence alone. He is not subjective in forming his opinion.

d) Professional Competence and Due Care: Auditor has attained certain professional
qualification, has acquired the requisite skill and has attained the experience necessary for
the audit and performs his work with planning and due diligence.

e) Confidentiality: Auditor neither discloses the information obtained during the course of
his audit without permission of his client (except when required in a court of law) nor uses
that information himself.

f) Professional Behavior: He should not only act in a professional manner but should also
appear to be a professional. He should maintain his professional knowledge and skill at a
level required to ensure that a client or employer receives the benefit of competent
professional service based on up-to-date developments in auditing practice and relevant
legislation.

g) Technical Standards:
Audit should be performed by following certain standards, international or national.

The auditor should conduct an audit in accordance with SLAuSs. These contain basic
principles and essential procedures together with related guidance in the form of
explanatory and other material.

The auditor should plan and perform an audit with an attitude of professional skepticism
recognizing that circumstances may exist that cause the financial statements to be
materially misstated.

Scope of an audit

The term “scope of an audit” refers to the audit procedures deemed necessary in the
circumstances to achieve the objective of the audit. The procedures required to conduct an audit
in accordance with SLAuSs should be determined by the auditor having regard to the
requirements of SLAuSs, the Institute of Chartered Accountants of Sri Lanka, legislation,
regulations and, where appropriate, the terms of the audit engagement and reporting
requirements.

Advantages of statutory audits

An external audit provides the following benefits:

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 It increases the credibility of published financial statements.
 It confirms to management that they have performed their statutory duties correctly.
 It provides assurance to management that they have complied with non-statutory
requirements, such as corporate governance requirements (where these are subject to
audit or review).
 It provides feedback on the effectiveness of internal controls. Where internal controls
are weak or inadequate, the auditor will give recommendations for improvement. This
will assist management in reducing risk and improving the performance of the
company.

Even where a statutory audit is not required, for example due to small company statutory
exemption limits, an audit will increase the credibility of published financial statements.
This may be important for potential lenders to the company. Potential lenders, such as
banks, may insist on the company having an audit as a pre-condition for lending money.

Limitations of statutory audits

The main limitations of an audit are as follows:

 Its cost. The cost of an audit can be very high. However, if the audit firm is already
hired to carry out non-audit work such as accounts preparation or advisory work, the
additional cost of an audit may be fairly small.
 The disruption caused to a company’s staff during the audit. The company’s staff may
be required to assist the auditors by answering questions, providing documents and
other information.
 Some items in the subject matter might be estimates whose truth and fairness will not
be known with certainty until some point in the future. This means the assurance
opinion is ultimately subjective and judgmental.
 Most fraud will include an attempt to deliberately conceal the truth or misrepresent
information.
 In order to balance cost and efficiency the auditor routinely uses sampling rather than
tests every item.
 Irrespective of how robust a client’s systems are they will always incorporate some
degree of inherent limitation.
 Audit evidence is persuasive rather than conclusive.

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