historical development 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 Auditing part I By: Yetnayet Ayele, AAUSC, 2015 1 Auditing was initially practiced in government settings The word auditing is derived from the Latin 'audire', meaning 'to listen'. In ancient time, Governmental accounting records were approved only after a public hearing in which the accounts were read aloud. A wise man that acts as an auditor is required to listen carefully to a spoken description of a situation, applied his judgment, and came to an opinion . Over time, auditing has developed and begin to be applied in both the private and the public sectors and both internally and externally. The development of auditing is highly related to the development of commerce, accounting and bookkeeping. Auditing part I By: Yetnayet Ayele, AAUSC, 2015 2 The invention of double entry in 1494, in Italy; the industrial revolution that took place in Great Britain, in 1980, which led to the emergence of large corporations resulted in the increased need for persons who check financial records. These developments resulted in the demand for the services of book-keeping and auditing (internal and external) who check the fairness of financial records.
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Brief Sketch of the major developments of Auditing in the 20th Century Ancient time: auditing was hearing of government accounts Medieval Period up to industrial Revolution: it is used to determine whether persons in positions of fiscal responsibility in government and commerce were acting and reporting in an honest manner. During Industrial Revolution (in Corporate setting): Owners need auditors to protect themselves against the danger of fraud by both managers and employees. In general, before 1900, auditing was concerned principally with the detection of frauds. Auditing part I By: Yetnayet Ayele, AAUSC, 2012 4 …Brief Sketch of the development of auditing In the first half of the 19th century, the direction of audit work tended to shift from fraud detection towards the new goal of determining whether financial statements gave a fair picture of financial position, operating results and changes in financial position. This shift in emphasis was a response to the needs of the millions of new investors in corporate securities
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…Brief Sketch of the development of auditing In recent years, the detection of large-scale management fraud has assumed a larger role in audit philosophy. The latest shift in emphasis is a result of the dramatic increase in the number of lawsuits charging that management fraud has gone undetected by independent auditors. (The situation has also increased the demand for modern internal audit).
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…Brief Sketch of the development of auditing Development of Sampling Techniques: In the early days of the auditing profession, auditing involves a complete review of all transactions. However, about 1900, as large scale business enterprises developed in Great Britain and US, auditors adopted sampling techniques. This new auditing technique transformed the audit process from detailed examination of individual transactions to the use of sample (testing selected transactions) Auditing part I By: Yetnayet Ayele, AAUSC, 2012 7 …Brief Sketch of the development of auditing Internal control as a basis for testing and sampling: Evaluation of client’s internal control system became a prerequisite to successful use of sampling techniques. By studying client’s accounting and internal control system (by considering the work flows), auditors could determine the extent and direction of the tests needed for a satisfactory audit of the financial statements. The stronger the internal control, the lesser testing required by the auditors. In areas where control is weak, auditors expand the scope and intensity of their tests. The development of new auditing techniques applicable Electronic data Processing System: Organization’s reliance on computers has not lessened the importance of internal control to auditors, however, it led auditors to develop new approaches to studying internal control. Auditing part I By: Yetnayet Ayele, AAUSC, 2012 8 Factors contributed for the development of Auditing Increase in complexity of business organizations Separation of ownership and management Legislative control- To safeguard the interests of shareholders and third parties, governments pass several laws (eg. Maintenance of books by companies, qualifications of auditors, manner of their appointment, their duties, rights and liabilities etc) Judicial pronouncements-Courts decisions on issues related to the legal liabilities of auditors. Computerized accounting
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The comprehensive 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 (A comprehensive definition cited in Ricchiute 1982). Auditing part I By: Yetnayet Ayele, AAUSC, 2015 10 From the above definitions it is possible to understand that auditing has the following attributes: 1. It is a systematic process – Auditors use logical, structured and organized steps and procedures to examine accounting records and other documents of an organization. 2. It involves a task of objectively obtaining and evaluating evidence : - Auditors form opinion based on evidences examined and evaluated without bias and prejudice 3. Auditing is conducted by competent and independent person – - an auditor is required to have the essential skill and experience and has to be independent to avoid bias.
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4. It involves evaluations of evidences regarding assertions about economic actions and events: The auditor acts as an independent third party engaged by the principal to assess the information provided by the agent and report on the fairness of the financial statements 5. Its determines and report on the degree of correspondence between the information and established criteria. The essence of auditing lies in checking realities against standards. To conduct an audit, there must be verifiable information and established criteria. Eg GAAPs/IFRS for financial statement audit; inland revenue codes for tax audit; etc Auditing part I By: Yetnayet Ayele, AAUSC, 2015 12 6. It involves Communicating the Results to interested users: Preparing the audit report is the final stage in the auditing process. The auditor’s findings are communicated to users- eg. stockholders, management, creditors, governmental agencies, and the public.
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The nature of auditing 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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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 title
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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. Accounting is essentially a constructive process which involves identifying, measuring, recording, organizing, summarizing and communicating information about economic events. Auditing, on the other hand, is a critical (evaluative) process involving gathering and evaluating audit evidences and communicating findings (about fairness of financial statements) based on these evidences . Links Ch 1\Link1 ch 1 Accounting Vs Auditing.docx
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Assurance Services Assurance services is a broader term that includes audits and a variety of other assurances about various representations of management. The AICPA Special Committee on Assurance Services developed the following definition: “Assurance services are independent professional services that improve the quality of information for decision makers”. According International Auditing Practices Committee (IAPC) “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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Major points in the definitions of Assurance Services: 1. The concept of independence is a key aspect of assurance services. Users rely on the assurance provider’s independence and derive value from the fact that he/she is unbiased and objective. (eg CPA) 2. The concept of professional services encompasses the application of professional judgment that is a unique attribute that the assurance provider brings to the engagement. (eg. CPAs bring their professional skepticism and objectivity to an engagement. Technology cannot replace the practitioner’s professional judgment.) 3. The purpose of assurance service is to improve the quality of information (to make information more useful for decision- decision usefulness). Assurance services improve the quality of information by improving its reliability or relevance. 4. Assurance services are intended to provide a benefit to the decision maker. Decision makers may be clients or outside parties.
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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. 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)
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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 compliance with specified criteria. Auditing part I By: Yetnayet Ayele, AAUSC, 2012 20 Levels of Assurance CPAs can provide several levels of assurance when performing assurance services. The common levels of assurance are described as follows: Reasonable Assurance: This is a very high level of assurance but not a guarantee. In audit and examination engagements, the CPA sufficient, competent evidence to support an opinion that the assertion is presented fairly in all material respects. Negative assurance or review level assurance-This is substantially less than an audit or examination. In a review engagement, the CPA makes inquires and performs analytical procedures so that the reviewer can state that he or she is “not aware of any material modifications that should be made to management’s assertion.” Agreed-upon procedures- In some cases the entity making an assertion and the entity using an assertion will agree on specific procedures to be performed by the CPA. The level of assurance that is obtained depends on the nature and extensiveness of the agreed-upon procedures performed by the CPA. Compilation without assurance- In some cases the CPA may compile information to provide decision makers with relevant information. In this case the CPA provides no assurance about the underlying reliability of the information. Auditing part I By: Yetnayet Ayele, AAUSC, 2012 21 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, ▪ Accounting (Bookkeeping) services include eg . doing manual or automated bookkeeping, journalizing, and posting adjusting entries. Usually small businesses may no have permanent accounting staff ▪ A Compilation Services: This involves the presentation of financial statements from the accounting records and other representation of the client. The purpose is to organize clients representations in to formal financial statements, not to provide assurance that financial statements are fairly presented for the CPA has not obtained evidence supporting the financial statements. Auditing part I By: Yetnayet Ayele, AAUSC, 2012 22 …Non Assurance Services Provided by CPAs 2. Tax services - the CPA’s responsibility is to see that the client pays the proper amount of tax and no more. In this role, the CPA may properly resolve questionable issues in favor of the client. The CPA is not required to maintain the posture of independence required in audit work. 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. -
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…Non Assurance Services Provided by CPAs Assurance services aim at improving the quality of information, but the primary purpose of eg. management consulting is to generate a recommendation to management Thus, reports from non assurance such as above provide no explicit assurance that the information is fairly presented. In US, trends show that CPA firms had a significant amount of revenue from consulting activities, but since rules such as the Sarbanes-Oxley do not allow auditors to perform consulting services to public company audit clients, the revenue from this source is expected to reduce in future.
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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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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. It may 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 company operations for management.
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…… Internal Audit The Institute of Internal Auditors (IIA) defined internal auditing as follows: “Internal auditing is an independent, objective assurance and consulting activity designed to add value and improve an organization's operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes”.
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…… Internal Audit It is conducted in accordance with management's requirement The reqiurements may be wide-ranging or narrowly-focused, and continous (ongoing) or one-off in nature. For example, it may be as broad as investigating the appropriateness of, and level of compliance with, the organization’s systems of internal control, or as narrow as examining the entity’s policies and procedures for ensuring compliance with health and safety regulations. Auditing part I By: Yetnayet Ayele, AAUSC, 2015 28 …… Internal Audit Internal auditors must be independent of the department heads and other executives whose work they review. Internal auditors, however, can never be independent in the same sense as the independent auditors because they are employees of the company they are examining. Two ways of maintaining independence for IA: 1. Reporting to the audit committee (Reporting to a level in the organization that does not affect its independence) 2.making internal auditors independent from the activities they audit
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External Audit It is 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 external audits. External audits are also described as a societal control which serves the needs of internal and, more importantly, external financial information users. Links Ch 1\Link 2 Ch 1 Internal Vs External Audit.docx External auditors conduct opinion audit Auditing part I By: Yetnayet Ayele, AAUSC, 2015 30 CPAs perform three major types of audits: 1. Financial statement audit 2. Compliance audit 3. Operational audit 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. Auditing part I By: Yetnayet Ayele, AAUSC, 2015 31 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 creditors, govt Auditing part I By: Yetnayet Ayele, AAUSC, 2015 32 Compliance audits are usually associated with government auditors -eg tax authority, the government internal auditing arm, or audit of bank by banking regulators eg to determine if banks comply with capital reserve requirements. Results of compliance audit are also reported to the management within the organizational unit being audited. Auditing part I By: Yetnayet Ayele, AAUSC, 2015 33 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. An operational audit may apply to the organization as a whole or to a segment of the organization, such as subsidiary, division or department. 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. Auditing part I By: Yetnayet Ayele, AAUSC, 2015 34 Forensic 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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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 Accountability Office Auditors, (Government Auditors) 3. Internal Revenue Agents, 4. Internal Auditors. 5. Forensic Auditors
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1. Certified Public Accounting Firms (Independent Auditors) These are CPAs who are either individual practitioners or members of public accounting firms who render services to clients. The title CPA/CPA firms indicate that those who express an audit opinions on financial statements should be licensed as CPAs. They provide services to clients on fee basis
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2. Government Accountability Office Auditors, (Government Auditors) Government auditors are employed by various local, state, and federal governmental agencies. They conduct comprehensive audits which combine elements of financial report, compliance and performance auditing. In US, the US Government Accountability Office (GAO) contains the Congress’s audit staff and is headed by the Comptroller General. The audit staff reports to the Congress GAOs assignment include: audits of government agencies Operational audits examinations of corporations holding government contracts
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In Ethiopia, Auditor General Office performs audit of Governmental Offices & Public Sector entities such as hospitals and educational institutions. These auditors perform Value-for Money Audits as part of Comprehensive Auditing. Comprehensive Auditing has three facets: The traditional financial attest audit, A compliance audit-in the private sector, (compliance with corporate policies, control procedures,); in the public sector, (compliance with government rules and regulations ); The Value for Money or operational Audit, which evaluates economy, efficiency and effectiveness. Effectiveness refers to the accomplishment of objectives while efficieny refers to the resources used to achieve those objectives. Economy means that resources are acquired in appropriate quantities when needed at the right price. The auditor will asses whether financial, human, and physical resources are managed with due regard to Economy, efficiency and Effectiveness (3Es). Auditing part I By: Yetnayet Ayele, AAUSC, 2015 39 Internal Revenue Agents
Internal revenue agents are auditors who are
responsible to determine whether tax payers returns/tax liabilities are properly calculated, recorded and paid to the government. They basically perform compliance audit. Auditors assigned in this area should have sufficient knowledge about tax laws and the skill to conduct an effective audit. Auditing part I By: Yetnayet Ayele, AAUSC, 2015 40 Internal Auditors Internal auditors are employees of the organization they audit; They are employed by individual companies to investigate and appraise the effectiveness of company operations for management. The scope of the internal audit function extends to all phases of organizational activities. A large part of their work consists compliance audit and operational audits. In many countries internal auditors are highly involved in financial audits. Auditing part I By: Yetnayet Ayele, AAUSC, 2015 41 ……Internal Auditors Internal auditors report directly to the highest authority in an organization or to the audit committee of the BODs. This strategic placement high in organization structure helps to assure that internal audits will have ready access to all units of the business, and that their recommendations will be given prompt attention by department heads. Auditing part I By: Yetnayet Ayele, AAUSC, 2015 42 Forensic Auditors Forensic auditors are employed by corporations, government agencies, public accounting firms, and consulting and investigative services firms. They are trained in detecting, investigating, and deterring fraud and white-collar crime
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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. Auditing part I By: Yetnayet Ayele, AAUSC, 2015 44 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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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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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 affairs. Auditing part I By: Yetnayet Ayele, AAUSC, 2015 47 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 the chance that transactions may be recorded improperly.
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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 (recommendations for improvement) Auditing part I By: Yetnayet Ayele, AAUSC, 2015 49 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. Limitations associated with the accounting system: Alternative Accounting Principles: alternative accounting principles are permitted under GAAP/, 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. Auditing part I By: Yetnayet Ayele, AAUSC, 2015 50
"The Language of Business: How Accounting Tells Your Story" "A Comprehensive Guide to Understanding, Interpreting, and Leveraging Financial Statements for Personal and Professional Success"