Audit Basics

Definition of Auditing
⬥ Auditing is the process by which a competent, independent
person accumulates and evaluates evidence about quantifiable
information related to a specific economic entity for the
purpose of determining and reporting on the degree of
correspondence between the quantifiable information and
established criteria.
-Arens and Loebbecke (1988)

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 Definition of Auditing
⬥ Auditing is a systematic process of objectively obtaining and
evaluating evidence regarding assertions about economic
actions and events to ascertain the degree of correspondence
between those assertions and established criteria and
communicating the results to interested users.

-American Accounting Association (AAA)

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 Definition of Auditing
⬥ An audit is an independent examination of financial
statements or related financial information of an entity,
whether profit oriented or not, and irrespective of its size, or
legal form, when such an examination is conducted with a view
to expressing an opinion thereon.

-International Federation of Accountants (IFAC)

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 Objective of an audit
Primary Objective of Audit: Expression of opinion

The objective of an audit of F/Ss is to enable to the auditor to

express an opinion whether the F/Ss 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.
-(BSA 200)
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 Objective of an audit
Secondary Objective of Audit:

Prevention and detection of material misstatements in the financial

statements, which are referred to frauds and errors; and
communication of weaknesses in the accounting and internal
control systems.

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 Why is there a demand for audits?
⬥ Agency Theory
⬥ Information Theory
⬥ Insurance Theory
⬥ Policeman Theory
⬥ Lending Credibility Theory
⬥ Theory of Inspired Confidence (Limperg, 1985)
⬥ Regulation

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 Economic Demand for Auditing
Demand Driver Information risk
Causes of Information risk:
⬥ Remoteness of information Audit can reduce the
⬥ Biases and motives of the provider information risk.
⬥ Voluminous data
⬥ Complex transactions

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Auditors, Client, and External Users Relationship

Client or audit Auditor issues

committee hires report relied
auditor Auditor upon by users to reduce
information risk

Provides capital
External
Client
Users
Client provides financial
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statements to users
‘’ An audit is a social phenomenon which serves no purpose
or value except of its practical usefulness and its existence
is wholly utilitarian.’’

-David Flint (1988)

Services provided by CA/CPA
⬥ Assurance service
⬥ Non-assurance service
⬥ Attestation service

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 Assurance
An assurance engagement is one in which a practitioner expresses
a conclusion designed to enhance the degree of confidence of the
intended users other than the responsible party about the
outcome of the evaluation or measurement of a subject matter
against criteria.

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Key elements of Assurance Engagement
1. Three party involvement
⬦ Practitioner
⬦ Responsible party
⬦ Intended users
2. Subject matter
3. Relevant criteria
4. Evidence
5. Written Report
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 How Audit is an Assurance Engagement?
1. Three party involvement 1. Three party involvement
⬦ Practitioner ⬦ Auditor
⬦ Responsible party ⬦ Management
⬦ Intended users ⬦ Shareholders/creditors
2. Subject matter 2. Financial Statements
3. Relevant criteria 3. IFRS, Companies Act, CGG
4. Evidence 4. Accounting records and others
5. Written Report 5. Audit Report
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 Level of Assurance
⬥ Absolute Assurance
100% assurance/guarantee about something. Quite impossible !
⬥ Reasonable Assurance
High level of assurance with positive expression of opinion i.e. Audit. “In our opinion the
financial statements present fairly in all material respect”
⬥ Limited Assurance
Moderate level of assurance with negative expression of opinion i.e. review, “Nothing has
come to our attention that indicates material misstatements in the financial statements”.
⬥ No Assurance
No Assurance provided e.g. non-attestation service.
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Why Absolute Assurance is impossible?
⬥ Nature of financial reporting
⬥ Nature of audit procedure
⬥ Time constraint
⬥ Cost – benefit analysis

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“An Auditor is a watchdog, not a
bloodhound”

-Case of Kingston Cotton Mills Co.

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 Responsibilities of management
⬥ Managing the business to achieve company’s objective
⬥ Assessing the business risk and managing the risk
⬥ Safeguarding the company’s assets
⬥ Keeping proper accounting records
⬥ Preparing the financial statements and delivering it to the
registrar of JSC
⬥ Ensuring the company compliance with applicable laws and
regulation

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 Responsibilities of Auditor
⬥ Conducting audit in accordance with BSA
⬥ Obtaining reasonable assurance that the financial statements are
free from material misstatement whether due to fraud or error
⬥ Proving appropriate opinion

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Who is responsible for the prevention and
detection of fraud?

- Management; not Auditor !

- “An Auditor is a watchdog, not a bloodhound”

Gatekeeper Detective

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 Scenario of Kingston Cotton Mills

⬥ Directors were incompetent, dishonest

✓ “No knowledge about business’’ – chairman
✓ “Directors should receive no remuneration when shareholders
receive no dividend” – Chairman
✓ 8% dividend when no profit
⬥ Poor Financial management (Gradual capital/call on share)
⬥ Operational inefficiency (mill in Hull not Liverpool )
⬥ “Auditors are the officer of the company” – Shareholders and Mr.
Justice Vaughan William.
⬥ “An auditor is a watchdog not a bloodhound” Justice 22
 Benefits of assurance/audit
⬥ Enhance the credibility of the information being reported on.
⬥ Reduces the risk of management bias, error or even fraud.
⬥ Draws the attention of the user to any deficiencies in the
information being reported on.
⬥ Ensure circulation of high quality, reliable information in the
market.
⬥ Give added faith to the investors in the market
⬥ Improve the reputation of organizations trading in the market.
⬥ Reduce the cost of capital (Rf + Rp+ Information Risk)
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Case Study
SP Ltd was established in June 20x0 to produce medicine. The shares are owned equally by two
executives and two non-executive directors.

The company’s revenue increased steadily over the first two years of trading. The results for the
first year of trading indicated an operating profit margin of 15% and the management accounts for
the second year of trading indicate that this has increased to 18%. The directors are currently
negotiating a contract worth TK 600,000 to supply a major retailer which has over 100 outlets
throughout the country. The company will require an increased overdraft facility to fulfill the order.
The finance director has prepared a business plan for submission to the company’s bankers in
support of a request for a large overdraft facility. The plan includes details of the company’s
products, management, markets, methods of operation and financial information. The financial
information includes profit and cash flow forecasts for the six months ending 31 December 20x2
together with details of the assumptions on which the forecasts are based and the accounting
policies used in compiling the profit forecast. The company’s bankers require this financial
information to be reviewed and reported on by independent accountants. The company was
required by its bankers to have an audit of its F/Ss for the year ended 30 June 20x1.

Requirement: What are benefits of audit for the company? 25

“Without Audit, no accountability;
without accountability, no control;
and if there is no control,
where is the seat of power?’’

- E. L. Normanton (1966)

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 How audit ensures accountability?
ACCOUNTABILITY AUDIT

Evidence
Subject Matter

Evidence
1. Preparer
Assertions

Accounting Reports 3. Auditors

Criteria

2. Users Auditor’s Reports

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Regulatory Framework
 Types of Audit
Based on Legal Requirement Based on Auditors type
⬥ Statutory Audit ⬥ Internal Audit
⬥ Non-statutory Audit ⬥ External/Independent Audit

Based on Subject matter Based on time Period

⬥ Operational Audit/Value for ⬥ Interim Audit
money (EEE) ⬥ Continuous Audit
⬥ Compliance Audit ⬥ Annual Audit 28
⬥ Financial Statement Audit
Types of Audit
Based on Audit Dimensions
⬥ Cost Audit
⬥ Management Audit
⬥ Social Audit
⬥ Tax Audit
⬥ Social Audit
⬥ Government Audit
⬥ Shariah Audit
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 Internal Audit VS External Audit
BASIS INTERNAL AUDIT EXTERNAL AUDIT
Meaning Internal Audit refers to an ongoing audit External Audit is an audit function performed by
function performed within an organization by a the independent body which is not a part of the
separate internal auditing department. organization.
Objective To review the routine activities and provide To analyze and verify the financial statement of
suggestion for the improvement. the company.
Conducted by Employees Third Party
Auditor is Management Members/Shareholders
appointed by
Users of Report Management Stakeholders
Opinion Opinion is provided on the effectiveness of the Opinion is provided on the truthfulness and
operational activities of the organization. fairness of the financial statement of the
company.
Scope Decided by the management of the entity. Decided by the statute.

Obligation No, it is voluntary Yes, according to Companies Act, 1994

Period Continuous Process Once in a year

Checks Operational Efficiency Accuracy and Validity of Financial Statement
 Accounting VS Auditing
Accounting is the recording, classifying, and summarizing
of economic events for the purpose of providing financial
information used in decision making.

Auditing is determining whether recorded information

properly reflects the economic events That occurred during
the accounting period.

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THANKS!
ANY QUESTIONS?

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