Auditing Principles

and Practices I
By: Kidane G. (BSc&MA)
June,2023
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Chapter Objectives
• Explain the general nature of auditing
• Describe how auditing differs from accounting
• Distinguish between financial statement audits,
compliance audits and operational audits
• Distinguish between external and internal audits
• Distinguish between different types of auditors
• Explain why financial statement audits are necessary

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 1.1 Definition and Nature 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.
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…. 1.1 Definition and Nature of Auditing
From the above definitions it is possible to
understand that auditing has the following
attributes:
1. It is a systematicprocess – Auditors use logical
structured and organized steps and procedures t
examine accounting records and other documents o
an organization.
2. It involves a task of objectively obtaining an
evaluating evidence: - Auditors form opinion base
on evidences examined and evaluated without bia
and prejudice 5
…. 1.1 Definition and Nature of Auditing
3. Auditing is conducted by competent and
independent person –
4. It involves evaluations of evidences regarding
assertions about economic actions and events:
5. Its determines and report on the degree of
correspondence between the information and
established criteria.
6. It involves Communicating the Results to
interested users:

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 …. 1.1 Definition and Nature
of
Auditing
• The nature of audit ing can also be summarized
as follows:
• Competent and independent person/s →
accumulate and evaluate evidence , ie,
verify if the information corresponds to
the established criteria → then based on
the evaluation, audit reports are prepared.

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 1.2 Auditing Vs Accounting
• Many users consider auditing and
accounting as similar mainly due to the
following:
• Most auditing is usually concerned with
accounting information
• Many auditors have considerable
expertise in accounting matters
• The title “Certified Public Accountants”,
is given to individuals performing audit
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title
 …. 1.2 Auditing Vs Accounting
Though the major raw material for auditing
work comes from the accounting data and the
accounting systems, the processes involved in
auditing and accounting are different.

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 Assurance and Non Assurance
Services
Assurance Services
• Assurance services is
a broader term that
includes audits and a variety of other
assurances about various representations
of management.
“Assurance services are independent
professional services that improve the
quality of information for decision
makers”.
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 Assurance and Non Assurance
Services

“Assurance (information credibility)

services are professional services, for use
by decision makers, designed to enhance
the credibility of information that is the
responsibility of another party by
evaluating that information against
suitable criteria”.
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 ..Assurance and Non Assurance
Services
Assurance services provides by CPAs:
1. Attest Services
2. Other assurance services
1. Attest Services
• Attest/Attestation service is one in which a
CPA firm issues a report about the
reliability of an assertion (statement about
something) that is made by another party.
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 ..Assurance and Non Assurance
Services
Attest services include the following four category of
services:
1. Audit engagement/ Audit of historical financial
statements
2. Effectiveness of internal control over financial
reporting
3. Review of historical financial statements (limited
investigation, far less in scope than audit)
4. Other attest services that may be applied to a broad
range of subject matter (eg agreed up on engagement
such as attesting amount of liabilities eg royalties
payable) 13
 … Assurance and Non
Assurance Services
2. Other Assurance services (other than
attestation services) provided by CPAs:
Eg. a CPA might provide assurance on a
company’s data backup procedures.
•These services are different from attestation
services in the following aspect:
•The CPA is not required to issue a written
report
•The assurance does not have to be about the
reliability of another party’s assertion about
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compliance with specified criteria.

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Assurance and Non Assurance Services

Non Assurance Services Provided by CPAs
• Services outside
the scope of assurance services are
commonly known non assurance services
• Commonly known Non Assurance Services rendered
by CPAs include:
1. Accounting (Bookkeeping ) and Compilation
services,
•A Compilation Services: This involves the
presentation of financial statements from the
accounting records and other representation of
the client. 17
 …Assurance and Non Assurance
Services
…Non Assurance Services Provided by CPAs
2. Taxservices - the CPA’s responsibility is to see
that the client pays the proper amount of tax
and no more.
3. Management Consulting Services –this
includes performing special studies and
investigations, making suggestions to
management, pointing out the existence of
weakness, outlining various alternative
corrective measures and making
recommendations. 18

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 1.3. Types of Audits
Audit may be classified in various ways. They may be
classified according to:
1. The primary beneficiary of the audit – Internal
and external Audit
2. The primary objectives of the audit –Financial
statement audits, Compliance audits, Operational
audits and Forensic audits

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 …1.3 Types of Audits
Internal Vs External Audit
• Internal Audit: it is an audit conducted by
employee of an organization into any aspect of
its operation
• It is conducted for parties (usually management)
internal to the entity.
• Itmay be performed by personnel from an
outside source (such as an accounting firm when
the service is outsourced.).
• Internal
auditors work focuses on investigation
and appraisal of the effectiveness of the 20

company operations for management.

 …1.3 Types of Audits
External Audit
• Itis an audit performed for parties external to
the auditee.
• Experts, independent of the auditee and its
personnel, conduct these audits
• The best known and most frequently performed
external audits are statutory audits (audits
carried out because the law requires them of
compliances)’ and public sector entities financial
statements (ie financial statement audits).
• Compliance audits
conducted by Customs office
and the Inland Revenue are also examples of 21

external audits.
 Financial, Compliance and Performance
Audit
• CPAs perform three major types of audits:
1. Financial statement audit
2. Compliance audit
3. Operational audit

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Financial statement audit
• It examines whether financial statements
give true and fair view of or fairly represent
the financial position, result and cash flows
• The results of financial statement audits are
distributed in the form of audit reports to
users such as shareholders, creditors,
regulatory agencies, and the general public
• In addition, the external auditor also
prepares a report to the audit committee of
the board of directors, about the company’s
accounting policies, internal controls and
other audit findings. 23
Compliance audit
•A compliance audit is a review of an
organization’s procedures to determine
whether certain financial or operating
activities of an entity confirm to specified
conditions, procedures, rules, or regulations
set by some higher authority.
•A compliance audit measures the compliance
of an entity with established criteria.
• The established criteria in this type of audit
may come from a variety of sources. Eg
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creditors, gov’t
Operational audit
• This type of audit is sometimes referred to as a
performance audit or a management audit.
• It is usually initiated by the entity’s management
and is conducted by competent, experienced
professionals (internal or external to the
organization) who report their findings to
management.
• The objective of the audit may be broad, for
example, to improve the overall efficiency of the
entity or narrow and designed for example, to solve
a specific problem such as excessive staff turnover.
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 …Financial, Compliance and
Forensic audit Performance Audit
• The purpose of forensic audit is the detection or deterrence
of a wide variety of fraudulent activities.
• Some examples where a forensic audit might be conducted
include:
• Business or employee fraud,
• Criminal investigation, Shareholder or partnership
disputes,
• Business economic losses and Matrimonial disputes
(divorce proceedings).
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 1.3.2. Types of Auditors
• Basically, auditors are divided into
independent/external auditors and internal
auditors. Governmental auditors take both the
functions of internal and external auditors.
• Depending on the skills they possess and the
activities they conduct, auditors can also be
commonly classified as:
1. Certified Public Accounting Firms (Independent Auditors)
2. Government Auditors
3. Internal Revenue Agents,
4. Internal Auditors.
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5. Forensic Auditors
 1.4. Demand for Auditing
Why Auditing is needed?
• It is needed to obtain assurance that financial
statements are relevant, reliable, are in conformance
to GAAPs (a measure of relevance of financial
information).
The Concept of Business Risk and Information Risk
• Business risk refers to events such as inflation,
competitors, increased tax, discontinuance of
government subsidies, employees strike and so on.
• Auditors do not directly influences a company’s
business risk, but have significant effect on
information risk.
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 1.4. Demand for Auditing
• Information Risk is a risk that results from the
use of inaccurate financial statements - the risk
that the financial statements may be incorrect,
incomplete, biased or misleading (not reliable,
not relevant). Auditing is needed since it reduces
information risk.
• Eg banks and other financial institutions reduce
information risk by relaying on audited financial
statements of borrowers.

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 1.4. Demand for Auditing
Four factors that create the demand for auditing
or the major causes of information risks that
justify auditing as follows:
1. Conflict of interest,
2. Consequences of error,
3. Remoteness
4.Volume & complexity of transaction.

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 1.4. Demand for Auditing
Conflict of interest
If information is provided by someone whose goal
is different/inconsistent from the decision maker,
the information may be biased in favor of the
provider.
Eg. between borrowers and lenders;
b/n board of directors and the owners of a
corporation; b/n tax payers and the government
Thus audit plays a vital role in helping to ensure
that preparers of financial statement provide,
and users are confident in receiving information
which is a fair representation of entity’s financial
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affairs.
 1.4. Demand for Auditing
Consequence of Error
If financial statement users base their decisions on
unreliable and misleading financial statements, they
may suffer serious financial loss
Remoteness
Legal, physical, and economic factors, constrain users not
to verify for themselves the reliability of the information
contained in the financial statements.
Volume and Complexity of transactions
As companies grow in size, the volume of their
transactions have also increased, this in turn will increase
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the chance that transactions may be recorded improperly.
 1.4. Demand for Auditing
Economic Benefits of an Audit
• Access to capital market (eg. the requirement that
without audit, companies cannot register securities and
trade on securities market)
• Low Cost of capital - the reduced information risk
associated with audited financial statements, makes
creditors to offer loans with lower interest rates to
borrowers.
• Deterrent to inefficiency and fraud
• Control and Operational improvements 33

(recommendations for improvement)

 Limitation of an Audit
• Reasonable Cost: a limitation on the cost of an audit
results in selective testing, or sampling, of the accounting
records and supporting data.
• Reasonable Length of Time: usually there is a time
constraint, and this may affect the amount of evidence
that can be obtained concerning subsequent events, and
the time may not be sufficient to resolve uncertainties
existing at the statement date.

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 Limitation of an Audit
Limitations associated with the accounting
system:
• Alternative Accounting Principles:
alternative accounting principles are permitted
under IFRS/, and it is the user that must be
knowledgeable about a company’s accounting
choices and their effect of financial statements.
• Accounting estimates: estimates are inherent
part of the accounting process, thus
uncertainties exist. An audit cannot add
exactness and certainty to financial statements
when these factors do not exist. 35
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