Chapter One

Identifying Fundamentals of Auditing

Learning Objectives:
After studying this chapter, students should be able to:

 Define auditing and describe the required parts of the definition;

 Identify code of ethics for auditors correctly;
 Identify the responsibilities of management and auditors correctly;
 Distinguish between different types of audits and auditors, based on
standardized classifications;
 Describe the need for financial statement audits, based on the
information needs of users;
 Distinguish between accounting and auditing emphasizing on objectives
and methodology.
 Describe the ten Generally Accepted Auditing Standards properly
(GAAS);
 Identify the format of auditor’s standard report based on their
content.

Auditing is concerned with verification of Accounting and financial records with

a view to determining their accuracy and reliability. Auditing involves
examination of books, accounts, and financial statements with the main
objective of determining whether this information reflects the economic events
that occurred during the accounting period.

Auditors provide assurance services about financial and nonfinancial

statement information, including audits of historical financial statements.
Auditors are valued because of their technique, knowledge and independence,
and they also assist companies in improving operations and internal controls.
Auditors often make suggestions that improve profitability by reducing costs,
including the reduction of errors and fraud, and by improving operational
efficiency.

This chapter will start discussion by defining auditing and identifying the
different types of audits and auditors, moreover, the auditors’ code of
professional ethics and Generally Accepted Auditing Standards will be
discussed in detail.

Auditing Principles and Practice I Chapter one Page 1

1.1 Task 1 Defining Auditing:
Auditing is an exercise whose objective is to enable Auditors to express an opinion whether the financial
statements give a true and fair view (or equivalent) of the entity’s affairs at the period end (balance sheet) and
its profit and loss (or income and expenditures) for the period then ended and have been properly prepared in
accordance with the applicable recording framework, where statutory or other requirements prescribe the term,
whether the financial statements “present fairly. (The Accounting Principles Board (APB)).

Auditing is the accumulation and evaluation of evidences about information to determine and report on the
degree of correspondence between the information and established criteria. Auditing should be done by a
competent, independent person. (Arens & Loebbecke).

Auditing is the examination, by an independent accountant, of the financial data, accounting

records, business documents, and other pertinent documents of an organization in order to attest to
the reasonableness of its financial statements. (Microsoft Encarta, 2005).

Auditing is systematic process of objectively obtaining and evaluating evidence regarding

assertions about economic actions and events to ascertain the degree of correspondence
between assertions and established criteria and communicating the results to interested users.
(The American Accounting Association, committee on Basic Auditing concepts)

These definitions include several key words and phrases. They tell us that to do
an audit there must be:
 Verifiable information and established criteria.
To do an audit there must be information in a verifiable form and some
standards by which the auditor can evaluate the information. Auditors
routinely audit quantifiable information, including companies’ financial
statements and income tax returns. Auditors also perform audits of more
subjective information, such as efficiency of manufacturing operations.

The criteria for evaluating information also vary depending on the

information being audited. For example, in the audit of historical
financial information, the criteria are usually generally accepted
accounting principles (GAAP).
 Accumulating and evaluating evidence
Evidence is any information used by the auditor to determine whether
the information being audited is stated in accordance with the
established criteria. Evidence can be oral testimony of the auditee
(Client), observations by the auditor, and written communication with
outsiders. It is important to obtain a sufficient quality and volume of
evidence to satisfy the purpose of the audit.
Determining the type and amount of evidence necessary and evaluating
whether the information corresponds to the established criteria is a critical
part of every audit.
 Competent, independent person
Auditing Principles and Practice I Chapter one Page 2
 Competence refers to the qualification of the auditor to understand the
criteria used and the ability to know the type and amount of evidence to
accumulate to reach at the proper conclusion after a careful examination
of evidences.
Independence refers to the unbiased mental attitude of the auditor.
Although absolute independence is impossible, auditors strive to
maintain a high level of independence to keep the confidence of users
relying on their report. Internal auditors try to keep their independence
by reporting directly to top management.
 Reporting
Preparation of audit report is the final stage in audit process. Audit
report is a communication of auditor’s findings to users. Though reports
differ in nature, they all must inform readers the degree of
correspondence between information and established criteria. Reports
also differ in form and can vary from the highly technical type usually
associated with financial statement audits to a simple oral report in the
case of an operational audit of small department’s effectiveness.

1.1.1 Objectives of Auditing

The auditor should be an independent person who is appointed to investigate

the organization, its records and the financial statements prepared from them,
and thus produce an opinion in the accuracy and correctness of financial
statements. Thus auditing objectives may be divided into primary and
subsidiary objectives.
 Primary Objectives
To produce a report by the auditor of his opinion of the truth and fairness of
financial statements so that any person reading and using them can have a
belief in them.
 Secondary Objectives

 To detect errors and frauds

 To prevent errors and frauds by deterrent and moral effect of the audit
 To provide spin-off effects. The auditor will be able to assist his client
with accounting, systems, taxation, financial and other problems
(Advisory service).

THE DEMAND FOR AUDITING

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

Auditing Principles and Practice I Chapter one Page 3

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
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

Auditing Principles and Practice I Chapter one Page 4

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.

1.2Distinction between Auditing and Accounting

Many financial statement users and members of the general public confuse
auditing with accounting. The confusion results because most auditing is
usually concerned with accounting information, and many auditors have
considerable expertise in accounting matters. Giving the title “Certified Public
Accountant” to many individuals who perform audit increases the confusion.

Accounting is the recording, classifying, and summarizing of economic events

in a logical manner for the purpose of providing financial information for
decision-making. The function of accounting is to provide qualitative
information in light of the principles and rules. Whereas, Auditing concern is
in determining whether the recorded information properly reflects the economic
events that occurred during the accounting period.

Because Accounting rules are the criteria for evaluating whether the
accounting information is properly recorded, any auditor involved with this
data must also thoroughly understand those rules. In context of auditing the
rules are Generally Accepted Accounting Principles (GAAP). Accountants also
must understand such rules. However the expertise (knowledge) that
distinguishes accountants from auditors is in accumulation and interpretation
of audit evidence. Unlike accountants, auditors decide on audit procedures,
number and type of items to test and evaluate results.

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.

1.3 Types of Audit and Auditors

1.3.1 Types of Audit

While there are many types of audit based on the definitions previously
provided, generally they are discussed under three types: financial statement
audits, compliance audits and operational audits. There are three types of
audits that Certified Public Accountants (CPAs) can perform.

1. Financial Statement Audit – is conducted to determine the overall

financial statements (the information being verified) are stated in
accordance with specified criteria, usually the GAAP. The financial
statements most often included are the statement of financial position

Auditing Principles and Practice I Chapter one Page 5

 (Balance Sheet), income statement, and statement of cash flow, including
accompanying footnotes (disclosures).

2. Operational Audit - is a review of nay part of an organization’s operating

procedures and methods for the purpose of evaluating efficiency and
effectiveness. The aim of an operational audit is to improve operations.

Since efficiency and effectiveness of operations are far more difficult to

evaluate objectively in operational audit and established criteria for
evaluating the information is an extremely subjective, operational audit
is more like management consulting than what is generally regarded as
auditing.

3. Compliance Audit – is used to determine whether the auditee is

following specific procedures, rules, or regulations set by some higher
authority. The regulations may be set by the organization, the
government or legal and regulatory bodies. Results of compliance audits
are generally reported to someone within the organizational unit being
audited rather than to external users.

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.

1. Independent Auditors - are responsible for auditing the published

historical financial statements of all publicly traded companies, most
other reasonably large companies, and many smaller companies and non
commercial organizations. CPA firms must be licensed in order to engage
in auditing activities. CPA auditors are often called external auditors or
Certified Public Accounting firms to distinguish them from internal
auditors.

2. Government Auditors – are a nonpartisan agency in the legislative

branch of the federal government. They are responsible primarily to
perform the audit functions for the congress. Much of the financial
statements prepared by government agencies are audited by government
auditors before submitted to congress. An increasing portion of the
government auditors audit efforts has been devoted to evaluate the
operational efficiency and effectiveness of various federal programs, these
government auditors are also known as General accounting office
auditors (GAOs).

3. Besides, Internal Revenue Agents (IRAs) who are tax auditors of the
government are responsible to audit the taxpayers’ returns to determine
whether they have complied with the tax laws. The audits performed by
the IRAs are solely compliance audits. An auditor involved in these areas
Auditing Principles and Practice I Chapter one Page 6
 must have considerable tax knowledge and auditing skills to conduct an
effective audit. 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.

4. Internal Auditors - are employed by individual companies to audit for

management and board of directors. Their duties vary from company to
company; many internal auditors are involved in operational audit. To
operate effectively, an internal auditor must be independent of the line
functions in an organization.

Auditing Principles and Practice I Chapter one Page 7