CHAPTER THREE

AUDITING PRINCIPLES AND TOOLS

3.1 Auditing Principles and Standards

Principles are general guidelines that help direct or chart goals and aims. Auditing
principles thus are broad guidelines that help identify auditing goals and objectives or help
to direct efforts towards goals. Principles are based on concepts or assumptions and/or
developed from a particular observation and convention/custom. There are certain basic
principles that underlie every audit. An auditor has to ensure compliance with these
principles in carrying out any audit. Therefore, he has to design his audit procedures and
reporting practices in an auditing situation that he can comply with these basic principles.

Auditing profession in many countries have attempted to embody these guidelines in their
professional association emblem. For example, in USA and UK, Truth, Fairness, and
Objectivity were identified as basic auditing principles. Others have tried to base their
auditing principles on accounting principles themselves. In Ethiopia, for example, the
Ethiopian professional association of Accountants and Auditors (EPAAA) had the
following as principle guidelines in its emblem “Forth Rightness or Uprightness above all”

Standards are authoritative rules for measuring the quality of performance. They serve as
rods against which work performed is compared and thus principles are translated in to
more practical and adherable terms. In this regard standards are more specific than
principles. The American Institute of certified Public accountants (AICPA) has formulated
the following 10 generally Accepted Auditing Standards (GAAS) categorized in to three.
The following diagram depicts the 10 GAASs categorized in to three broad classifications.
Generally Accepted
Auditing Standards

A) General Standards B) Standards of Field Work C) Standards of Reporting

Adequate Training Proper planning & In Accordance with

& proficiency supervision GAAP
Understanding Internal Deviations from
Independence control GAAP
Adequate Disclosure
Due professional Sufficient &
care Competent Evidence Expression of
opinion

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 A. GENERAL STANDAREDS
1. Adequate Training and Proficiency: The audit is to be performed by a person or
persons having adequate technical training and proficiency as an auditor. How does
the independent auditor achieves the adequate technical training and proficiency
required by the first general standard? This requirement is usually interpreted to mean
college or university education in accounting and auditing, substantial public
accounting experience, ability to use procedures suitable for computer based systems,
and participation in continuing education program. A technical knowledge of the
industry in which the client operates is also part of the personal qualification of the
auditor. It follows that a CPA firm must not accept an audit engagement without first
determining that members of its staff have the technical training and proficiency
needed to function effectively in particular industry.

2. Independence: In all matters relating to the auditing assignment, independence in

mental attitude and in appearance is to be maintained by the auditor or auditors. An
opinion by independent public accountant as to the fairness of a company’s financial
statement is of no value unless the accountant is truly independent. Consequently, the
auditing standard that state in all matters relating to the assignment, an independent in
mental attitude is to be maintained by the auditors, perhaps is the most essential factor
in the existence of a public accounting profession. If an auditor owned shares of stock
in a company that they audited, or if they served as members of the board of directors,
they might subconsciously be biased in the performance of auditing duties. A CPA
should therefore avoid any relationship with the client that would cause an outsider
who had knowledge of the facts to doubt the CPA independent. It is not enough that
the CPA be independence, they must conduct themselves in such a manner that
informed members of the public will have no reason to doubt their independence.

3. Due Professional Care: the third general standard requires due professional care
in the conduct of an audit and in the preparation of the audit report. This standard
requires the auditor to carry steps of the audit engagement in an alert and diligent
manner. Full compliance with this standard would rule out any negligent acts or
material omissions by the auditors. Of course, auditors, as well as members of other
profession, inevitably make occasional errors in judgment, but this human element
doesn’t justify indifference or inattention to professional responsibility.
B. STANDAREDS OF FIELD WORK
4. Adequate Planning and Supervision: adequate planning is essential to a
satisfactory audit. Some portion of the examination can be performed prior to the end
of the year under audit: some information may be completed by the client’s staff and
made available for the auditors review. The appropriate number of audit staff of
various levels of skill and the time required of each need to be determined in advance
of filed work. These are but a few of the elements of planning the audit. Most of the
filed work of an audit is carried out by staff members with limited experience. The
key to successful use of relatively new staff members is close supervision at every
level. This concept extends from providing specific written instruction to staff
members all the way to an overall review by the partner in charge of the engagement.

5. Sufficient Understanding of Internal Control: An excellent internal control

structure provides strong assurance that the clients records are dependable and that its
assets are protected. When the auditor find this type of strong internal control, the
quality of other evidence required is much less than if control were weak. Thus, the

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auditor’s assessment of internal control has great impact on the length and nature of
the audit process.

6. Sufficient Competent Evidential Matter

The third standards of filed work require that the auditor gather sufficient competent
evidence to have a basis for expressing an opinion on the financial statement. The
word “competent” refers to the quality of the evidence; some forms of evidence are
stronger and more convincing than other.

C. STANDARDS OF REPORTING
There are four reporting standards that require the auditor to prepare a report on the
financial statement taken as a whole, including informative disclosure. The reporting
standards requires that the report states whether the statements are presented in
accordance with GAAP and also identify any circumstances in which GAAP have not
been consistently applied in the current year compared with the previous one.
7. In Accordance with GAAP: The report shall state whether the financial statements
are presented in accordance with Generally Accepted Accounting Principles.
8. Deviations from GAAP: The report shall identify those circumstances in which
such principles haven’t been consistently observed in the current period in relation to
the preceding period.
9. Adequate Disclosure: Informative disclosures in the financial statements are to be
regarded as reasonably adequate unless otherwise stated in the report.
10. Expression of Opinion: The report shall either contain an expression of opinion
regarding the financial statements, taken as a whole, or an assertion to the effect that
an opinion cannot be expressed; the reasons therefore, should be stated. In all cases
where an auditor’s name is associated with financial statements, the report should
contain a clear-cut indication of the character of the auditor’s work, if any, and the
degree of responsibility the auditor is taking.

The above 10 standards are also acceptable by the Canadian institute of chartered
accountant and more or less by many UK professional public accounting associations
(ACCA and CA). Therefore we can say that these standards are acceptable worldwide

3.2 Financial Statement Assertions

Assertions are expressed or implied representation by the management that are
reflected in the financial statement components. For example, when the balance sheet
contains account receivable of Br. 5 million, management asserts that receivables
exist and have a net realizable value of Br. 5 million. Management also asserts that
the account receivables balances arose from selling goods or services on credit in the
normal course of the business. In general, the assertions relates to the requirements of
GAAP. These assertions are parts of the criteria management uses to record and
disclose accounting information in financial statements. Auditors must there for
understand the assertions to adequately audit. That is to confirm client’s financial
statements to GAAP. Auditing standard classifies assertions in to five categories
1. Existence or Occurrence Assertion: these deals with whether transactions
recorded in journal or balances in the ledger have actually occurred during a given
period and whether assets or liabilities of the entity actually exist at a given date. For
example, management asserts that inventory shown on the balance sheet physically
exists and is available for sales. Similarly, management asserts that revenue reported
in the income statement represents valid sales that occurred during the period

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2. Completeness: assertion about completeness address whether all transactions and
accounts that should be presented in the financial statement are included. For example
management asserts that inventory represent all items on hand at the balance sheet
date. Managements also implicitly asserts that the amount shown for account payable
on the balance sheet includes all such liabilities on the balance sheet date
3. Right and Obligation: assertion about rights and obligation address whether assets
are the rights to the entity and liabilities are obligations of the entity at a given date.
For example, management asserts that the entity has legal title or rights of ownership
to the inventory shown on the balance. Similarly amounts capitalized for lease reflects
assertions that the entity has right to leased property and that the corresponding lease
labiality represents an obligation of the entity.
4. Valuation or Allocation: assertions about valuation and allocation address
whether assets, liabilities, equities, revenue and expense components have been
included in the financial statements at appropriate amount. For example, management
asserts that inventory is carried at the lower of cost or market value on the balance
sheet date. Similarly, managements assert that the cost of property, plants and
equipments is systematically allocated to appropriate accounting periods by
recognizing depreciation expense.
5. Presentation and Disclosure: assertion about presentation and disclosure address
whether particular components of financial statements are properly classified,
described and disclosed. For example, management asserts that the portion of long
term debt shown as current liability will mature in the current year. Similarly,
managements assert, through footnote disclosure that all major restriction on the
entity resulting from debt covenants is disclosed.

3.3 Audit Planning

The first Generally Accepted Auditing Standards of fieldwork requires adequate
planning to be made before auditing is carried out. Reasons for proper audit plan
includes
 To enable the auditor obtain sufficient competent evidence
 To help keep audit costs reasonable
 To avoid misunderstanding with the client
Obtaining sufficient competent evidence is essential if the CPA wants to minimize
legal liability and maintain a good reputation in the business community keeping costs
reasonable. It helps the firm remains competitive and thereby retains or expands its
client base, assuming the firm has a reputation for doing high-quality work. Avoiding
misunderstanding with the client is important for good client relations and for
facilitating high-quality work at reasonable cost. The followings are the elements of
audit planning:
1. Pre planning
2. Obtain background information
3. Obtain information about clients legal obligation
4. Perform preliminary analytical procedures
5. Set materiality, and assess acceptable audit risk and inherent
risk
6. Understand internal control and assess control risk
7. Develop overall audit plan or audit program
As shown above, there are seven major parts of Audit planning. Each of the first six
parts are intended to help the auditor develop the last part, an effective and efficient
overall audit plan and audit program.

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 1. Pre plan the Audit: Pre planning the audit involves four things, all of which
should be done early in the audit.
 A decision whether to accept a new client or continue serving an existing
one
 Identification of why the client needs an audit
 Obtaining an understanding with the client about the terms of
engagement to avoid misunderstandings.
 Select staff for engagement
Investigation of new client and re evaluation of existing ones is important to assess
the integrity of the client and to assess the acceptable financial risk it will assume. If
the CPA firm decides that acceptable risk is extremely low, it may choose not to
accept the engagement. If the CPA firm concludes that acceptable audit risk is low but
the client is still acceptable, it is likely to affect result and the fee proposed to the
client, Audits with low acceptable audit risk will normally result in higher audit costs,
which should be reflected in higher audit fees.

Obtaining an understanding with the client is expressed by the use of engagement

letter, even though it is not required. Engagement letter is an agreement between the
CPA firm and the client for the conduct of the audit and related services. It should
specify whether the auditor will perform an audit, a review, or a compilation, plus any
other service such as tax returns or management consulting. It should also state any
restriction to be provided for the audit, an agreement on fees. The engagement letter is
also a means of informing the client that the auditor cannot guarantee that all acts of
fraud will be discovered. Selection of staff for engagement involves the assignment of
appropriate staff to the engagement if the CPA firm decides to accept the client and
conduct the audit. Selection of audit staff is important to meet the first requirement of
generally accepted auditing standard and to promote audit efficiency. The first GAAS
stats “that the audit is performed by a person or persons having adequate technical
training and proficiency as an auditor”.

2. Obtain Background Information: An extensive understanding of the client

business and industry and knowledge about the company’s operation are essential for
doing adequate audit. There are three reasons for obtaining a good understanding of
the clients industry. First, many industries have unique accounting requirement that
the auditor must understand to evaluate whether the clients financial statement are in
accordance with GAAP. Second, auditors can often identify risks that may affect the
auditor’s assessment of acceptable audit risk, or even whether auditing companies in
the industry is advisable.
Finally, there are inherent risks that are typically common to all clients in certain
industry. Understanding those risks aids the auditor in identifying the client’s inherent
risk. Knowledge of the clients industry can be obtained in different ways. These
includes:
 Discussion with previous auditor
 Discussion with clients personnel
 Tour the plant and office of the clients
 Discussion with outside specialists.

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3. Obtain Information about Client’s Legal Documents: Early knowledge of the
legal documents and records enables auditors to interpret related evidence throughout
the engagement and to make sure there is proper disclosure in the financial statement.
Three closely related types of legal documents and records should be examined early
in the engagement.
 The Corporate Charter and the Bylaws: The corporate charter is
granted by the state in which the company is incorporated and is the
legal document necessary for recognizing a corporation as a separate
entity. It includes the exact name of the corporation, the date of
incorporation, the kind and amount of capital stock the corporation is
authorized to issue and the types of business activities the corporation
is authorized to conduct. The bylaw includes the rules and procedures
adopted by stockholders of the corporation; they specify such things as
the fiscal year of the corporation, the frequency of stockholders
meetings, and the methods of voting for directors, and the duties and
power of the corporate offices.
 The Corporate Minutes: are the official records of the meetings of
the boards of directors and stockholders. They include summaries of
the most important decision made by the directors and stockholders.
The auditors should read the minute to obtain information that is
relevant to perform the audit including the authorization and discussion
by the board of directors affecting inherent risk.
 Contracts: clients involved in different types of contracts that are
interested to the auditors. These can include various items such as long
term notes and bonds payable, stock option, pension plane, contracts of
manufactured products, contracts with vendors for future deliveries of
supplies, government contacts and leas.
4. Performing Preliminary Analytical Procedures: Auditors are required to
perform analytical procedures while planning the audit to assist the auditor in
determining the nature, timing and extent of auditing procedures. Analytical
procedures made during the planning phase enhance the auditors understanding of the
client’s business and events occurring since the prior year’s audit. Planning analytical
procedures also help the auditor identify areas that may represent specific risks of
material misstatement warranting further attention.

5. Audit Risk Assessment and Materiality: Audit risk represent the risk that the
auditor will conclude that financial statement are fairly stated and unqualified opinion
can be issued when in fact they are misstated. Audit risk refers to the possibility that
the auditor may unknowingly fail to appropriately modify their opinion on financial
statement that is materially misstated.
Audit risks are divided in to four:
a) Inherent Risk
b) Control Risk
c) Detection Risk
d) Acceptable Audit Risk
a. Inherent Risks: is a measure of the sensitivity or susceptibility of the financial
statement account to material misstatement before considering the effectiveness of
internal control, accounting controls, policies or procedures. Internal control is
ignored in setting inherent risk because they are considered separately in audit risk
assessment as control risk.

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b. Control Risk: is the risk that a material misstatement will not be prevented or
detected on timely basis by the clients internal control structure. Control risk represent
an assessment of whether clients internal control structure is effective for prevention
or detecting error and the more effective the internal control, the lower the control risk
c. Detection Risk: is the audit risk that the auditor will fail to detect material
misstatement with their audit procedures. It is the possibility that audit procedures
will lead them to conclude that a material misstatement does not exist in an account,
in fact such misstatement does exist. Detection risk is a function of the procedures
auditors perform for testing assertions.
d. Acceptable Audit Risk: is the measure of how willing the auditor is to accept that
the financial statement may be martially misstated after the audit is completed and
unqualified opinion has been issued. When the auditor decides on lower acceptable
risk, the auditor wants to be more certain that the financial statement will not
materially misstated. Zero acceptable risk would be high certainty and 100%
acceptable audit risk would be complete uncertainty. The primary way that the
auditors deal with risk in planning audit evidence is through the application of the
audit risk model. The audit risk model is used primarily for planning purposes in
deciding how much evidence to accumulate in each cycle.
6 . Develop an Over All Audit Plan
The last step in the planning the audit is to develop an over all strategy. This involve
about the nature, extent, and timing of audit test to be conducted. The audit strategy is
normally documented in an audit plan and audit program containing specific audit
procedures. The audit program for most audits is designed in three parts:
1. Test of transactions
2. Analytical procedures
3. Test of details of balance
3.4 Auditor’s Working Paper
Working papers are the records kept by the auditor of the procedures applied, the test
performance, the information obtained and the pertinent conclusions reached in the
engagement. The over all objectives of working paper are to aid the auditor in
providing reasonable assurance that an adequate audit was conducted in accordance
with GAAS. The working papers as they pertains to the current years has the
following purpose
 Provide a base for planning the audit, because the working papers describe
information about internal control structure, a time budget for individual
audit areas, the audit program and the results of the preceding year’s audit.
 A record of the evidence accumulated and the result of the test
 Data for determining the proper type of audit
 Basis for review by supervisor and partner. The working papers are the
primary frame of reference used by supervisory personal to evaluate
weather sufficient competent evidence was accumulated to justify audit
reports.
Working papers contain virtually every thing involved in the examination. The
filling of working paper is classified in to the following.

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 1. Permanent Files: are intended to contain data of a historical or continuing
nature pertinent to the current examination. The permanent files typically include
the following.
 Extracts or copies such as articles of in corporation, by laws and contracts.
 Analysis from previous years of accounts that have continuing importance
to the auditor such as long term debt, stock holders equality accounts, good
will and fixed asset.
 Information related to the understanding of the internal control structure
and assessment of control risks such as organization charts, flowcharts
questioners etc.
 Result of analytical procedures from previous year’s audit such as ratio
and percentage computed by the auditor.
 Total balance for selected accounts.
2. Current Files: The current files include all working papers applicable to the
years under audit. The types of information included in the current file are:
 Audit program
 General information like planning memos, copies of minutes, agreements
notes on discussion with client etc.
 Working trial balance, listing of the general ledger account and their year
end balance including subsidiary balance and account.
 Adjusting and reclassification entries
 Supporting schedule such as analysis of account trail balance,
reconciliation of amounts, test of reasonableness, summary of procedures,
examination of supporting documents, outside documentation.

The working paper prepared during the engagement, including those prepared by the
client for the auditor are the property of the auditor. The only time any one including
the client has legal right to examine the paper is, when they are subpoenaed by the
court as legal evidence. At the completion of the engagement, working paper is kept
at the auditors premise for future reference. The working paper can be provided to
some one else with expressed permission of the client