Chapter One

An Overview of Auditing

 Introduction
This chapter presents background information about the nature of auditing. It describes what auditing is and why it
is needed. Moreover, it introduces you to various types of audits and auditors. Auditing is the accumulation and
evaluation of evidence about information to determine and report on the degree of correspondence between the
information and the established criteria.
Objectives:
After studying this unit, you will be able to:
 Define auditing
 Describe various reasons why auditing is needed
 Distinguish between auditing and accounting
 Describe the various types of auditors and audits and
 Describe the influential auditing principles developing firms
1.1 Meaning and nature of auditing
Auditing is the accumulation and evaluation of evidence about information to determine and report on the degree of
correspondence between the information and established criteria.
Accounting principles Board (APB): According to APB, Auditing is an exercise whose objective is to enable
auditors to express an opinion, whether the financial statements give true and fair view of the entity’s affairs at the
end of the period (balance sheet) and its profit and loss for the period then ended and whether they have been
properly prepared in accordance with the applicable framework, where statutory and other requirements prescribe
the term.

International Federation of Accountants (IFA): An audit is an independent examination of financial information

of an entity, whether profit-oriented or not and irrespective of its size or legal form, when such an examination is
connected with a view to expressing an opinion thereon.

The American Accounting Association (AAA) defines auditing as follows:

Auditing is a systematic process of objectively obtaining and evaluating evidence regarding assertions about
economic actions and events to determine the degree of correspondence between the assertions and established
criteria and communicating the results to interested users.
This definition contains the following key words and phrases which are important in a wide variety of audit
practices.
 Systematic Approach: Auditing is purposeful and logical and it is based on the disciplines of a structured
approach to decision making. It is not haphazard, unplanned or unstructured.

1|Page
 Obtaining and evaluating evidence: auditing involves a process of obtaining and evaluating evidence that
ultimately guides the auditor’s decision. Evidence is any information used by the auditor’s to determine whether
the information being audited is stated in accordance with the established criteria.
 Assertions about Economic actions and events: In any audit engagement, an auditor is given financial
statements and other disclosures by management. Through these reports the auditor obtains managements’
explicit assertions about economic events and events
 Ascertain the degree of correspondence between the assertions and economic criteria
The purpose of obtaining and evaluating evidence is to ascertain the degree of correspondence between
the assertions and established criteria.
 Established criteria: In auditing the auditor checks if financial statements are prepared in accordance with
some established and accepted criteria or standard. The criteria usually used are called generally accepted
accounting standards(GAAP)
 Communicating the results: Auditors will ultimately communicate their findings to interested users through
their final audit report.

The above definition of auditing is more general. In more specific terms: auditing is a work performed by an
auditor to enable him/her to express an opinion on whether the financial statements are prepared in all material
respects in accordance with generally accepted accounting principles (GAAP). An important point that you
should note here is that an auditor doesn’t certify or guarantee that the financial statements are correct. He/she just
gives an opinion as to whether the financial statements are free from material misstatements.
Thus an auditor only gives a reasonable assurance that the financial statements are free from material
misstatements. An auditor may fail to detect even material misstatements because of two reasons: These are:
1-An audit is conducted based on a sample and
2-Auditors rely on internal control systems of the organization to determine the amount of work they have
to perform and the type and quantity of evidence to be gathered. However, internal control systems have their
own inherent limitations.

Activity: Define what auditing is about?

1.2 Need for Audit

An important question a student might ask is “why do organizations require an audit?”
Dependable financial information is essential to the very existence of our society. There are a number of
advantages in conducting auditing. The most significant of these are:
 A Tool for control: The first advantage of auditing is that it serves as a tool to control over those who
handle the resources belonging to others. Audit seeks to ensure that the officials use the public funds
properly. It has been a function of auditing to act as a check on those who handle the funds belonging to

2|Page
 others. The mere fact that there would be an audit of accounts acts as a check on those using the funds and
makes them cautious. Moreover, it acts as a moral check on employees, since they fear that the auditor
would discover any errors or frauds. Thus, it acts as a means of protecting against misuse of funds and
reduces the possibility of errors and frauds.
 Enhancing credibility of information: Another important advantage of auditing is that it enhances the
credibility of economic information. It is obvious that one would place greater reliance on financial
statement if it has been audited than would be the case otherwise. That is auditors lend credibility to the
financial statements. This is because the auditor is an independent and objective expert who has no any
stake in the management of the enterprise under audit. Auditors in their audit report express an opinion that
the company’s presentation of financial position, results of operations and changes in financial position is
in accordance with generally accepted accounting principles or some other disclosed basis of accounting.
 Improving economy and efficiency: In any type of audit engagement, the auditor reviews the activities of
the enterprise and often forwards suggestions to improve the efficiency of various activities of the
enterprise. Performance audit specifically is designed to review the operations and activities so that
wastages and losses can be minimized, weaknesses in the system can be identified and overcome and
controls can be strengthened. In general auditing enhances efficient utilization of resources.
 Regulatory requirements make auditing mandatory: In many countries, it is a must for business
organizations to file their audited financial statements to renew their licenses and permits. Some types of
audits are conducted for certain special purposes. Income tax laws of many countries provide for audit of
accounts of large businesses, primarily as an aid to the tax authorities. Some organizations are legally
required to get their financial statements audited. For instance, the 1960 Commercial code of Ethiopia
requires any share company in Ethiopia to get books of accounts audited annually so as to renew their
license.
Though auditing has the above advantages along with others, just like any other professional services, auditing
has its own limitations. Some of these limitations are:
 Its opinion is based on sampling. i.e... It does not look at 100% of transactions
 It cannot predict future events
 It may fail to detect fraudulent transactions (management fraud).
 Evidence obtained is persuasive, rather than conclusive
 Provides reasonable assurance, not absolute assurance

Activity- Answer the following questions as per the instructions given below
A-How do you define auditing?
B-What are the benefits of auditing?
C-Auditors only give reasonable assurance but not absolute assurance about the fairness of
financial statement Presentations. Describe why auditors do not provide an Absolute assurance?

3|Page
 1.3 Distinction between Auditing and Accounting

Many financial statement users and members of the general public confuse auditing with accounting. The
confusion arises because most auditing is concerned with accounting information and many auditors have
considerable expertise in accounting matters. The title Certified Public Accountants (CPA) which is given to
individuals performing an audit function has increased the degree of confusion.
Accounting is the process of recording, classifying, summarizing and communicating economic events in a
logical manner for the purpose of providing financial information for decision-making. The function of
accounting is to provide certain types of quantitative that management and others can use to make decisions. To
provide relevant information, accountants must have a thorough understanding of the principles and rules that
provide the basis for preparing the accounting information. Accounting as a process is constructive in that it
starts with raw financial data and produces financial statements as an end product.
Auditing on the other hand is analytical in that it starts with the end product of accounting (financial statements)
and tries to determine if the financial statements have been prepared in accordance with generally accepted
accounting principles. In auditing the concern is with determining whether recorded information properly
reflects the economic events that occurred during the accounting period. Since the accounting rules are the
criteria for evaluating whether the accounting information is properly recorded, any auditor involved with these
data must also thoroughly understand the rules. In the context of the audit of financial statements, the generally
accepted accounting principles (GAAP) are the basis for evaluating the fairness of the information presented in
financial statements. We can say that an auditor can also be called an accountant. However, auditors need to
know not only GAAP but also how to select and evaluate evidence related to financial statements.
This means that in addition to understanding accounting, the auditor must also possess expertise in the
accumulation and interpretation of audit evidence. It is this expertise that distinguishes auditors from
accountants. Determining the proper audit procedures, sample size, particular items to examine, timing of the
tests and evaluating the results are problems unique to auditing
Table1.The comparison of Accounting and Auditing

Basis of comparison Accounting Auditing

Primary responsibility Preparation of financial Audit of financial
statement statements
Criteria in discharging Generally accepted Generally accepted
responsibilities accounting principles auditing standards
(GAAP) (GAAS)
Its nature Constructive Analytical
End product Financial statements Audit reports
4|Page
The relationship between accounting and auditing is just similar to the relationship that exists between bookkeeping
and accounting. Just as accounting begins with the end results of bookkeeping, auditing begins with the end results
of accounting. In other words, accounting begins where bookkeeping ends and auditing begins where accounting
ends
1.4 Types of audits
There are different types of audits conducted by different types of auditors. Such difference is based on the
scope and objective of the audit and employment of the auditors. Auditors perform different types of audits.
Mainly there are four types of audits: financial statement audit, operational audit, compliance audit and forensic
audit.
1.4.1 Financial statement audit:
This type of audit is conducted to determine whether the overall financial statements such as income statement,
balance sheet, statements of retained earnings and cash flow statements are stated in conformity with generally
accepted accounting principles, although it is common to conduct audits of financial statements prepared using
other assumptions.
The assumption underlying an audit of financial statements is that different groups will use these statements for
different purposes. Therefore, the contribution of an independent auditor is to give credibility to financial
statements. Credibility means that the financial statements can be believed; that is they can be relied upon by
outsiders. Audited financial statements are now the accepted means by which business corporations report their
operating results and the financial position. Financial statements prepared by management and transmitted to
outsiders without first being audited by independent auditors leave a credibility gap. The product of financial
statement audit is an auditor’s report through which the auditor expresses his/her opinion. There are four types
of audit reports; namely, unqualified, qualified, adverse and disclaimer.

1.4.2 Operational audit:

An operational audit is a review of any part of an organization’s operating procedures and methods for the purpose
of evaluating efficiency and effectiveness. At the completion of an operational audit, recommendations to the
management for improving operations are normally expected. This audit is designed to measure the performance of
an organization, which can be evaluated in terms of efficiency and effectiveness. This type of audit as it aims on
measuring the performance of the organization is sometimes called performance audit. Because the criteria for
measuring effectiveness and efficiency are not as clearly established as are generally accepted accounting principles
or tax regulations, an operational audit tends to require more subjective judgment than other types of audits. In this
sense, operational auditing is more similar to management consulting and hence sometimes it is called management
audit. Some of the functions of the operational audit are:
 Planning the work to be performed including the setting of standards by which the audits is to be evaluated

5|Page
  Gathering evidence to measure the performance of the operation
 Analyzing and investigating deviations
 Suggesting corrective actions, where needed , and
 Reporting the results to the appropriate levels of management.
Generally, operational audit helps the organization to effectively allocate resources, identify problems at early
stage, improve communication, and increase profitability. An operational audit requires subjective judgment
since the criteria for measuring effectiveness and efficiency are not clearly established. The end product of an
operational audit is usually a report to top management containing recommendations for improvements in
operations
1.4.3 Compliance Audit:
This type of audit helps to determine whether the audit is following specific procedures or rules set out by some
higher authority such as management, government, board of directors etc. The performance of compliance audit is
dependent upon the existence of verifiable data and of recognized criteria or standards established by an
authoritative body. A familiar example is the audit of an income tax return by an auditor of the Inland Revenue
Authority (IRA).
1.4.4 Forensic audit: A forensic audit’s purpose is the detection of a wide variety of fraudulent activities. Some
of the examples where a forensic audit might be conducted include:
-Business or employee fraud
-criminal investigations
-shareholders and partners disputes
-Business economic losses
1.5 Types of auditors
The types of auditors differ as the types of audits. Although our interest is primarily in the audit of financial
statements by certified public accountants, other professional groups carry on large-scale auditing programs.
There are three most widely known types of auditor: these are Independent auditors, Government auditors and
internal auditors.

Independent Auditors: An independent auditor, also known as Certified Public Accountant or external auditor has
no connection to the organization being audited. Auditor’s primarily responsibility is the performance of the audit
function on published financial statements of the companies for a given period of time. The CPA certificate is not
only a license to practice but also a symbol of technical competence. Being a certified public accountant involves
passing rigorous examinations, obtaining practical experience and maintaining competence through continuing
professional education. However, the requirement as to the amount of education and public accounting experience
may differ considerably among the various countries. The type of audit usually conducted by independent auditor is
financial statement audit. In Ethiopia, The authorized auditors perform financial statement audit. In addition, The
Audit Service Corporation, a government-owned organization, performs financial statement audit.

6|Page
 Independent auditors perform financial statement, compliance and operational audits on fee basis. That is they
are not employees of the organization where they audit. Independent auditors usually perform four broad
categories of services such as attestation service, tax service, management advisory service and accounting
service.
Internal Auditors: These are auditors employed by individual companies and these are the employees of the
organization. A principal goal of the internal auditors is to investigate and appraise the effectiveness with which
the various organizational units of the company are carrying out their assigned functions. These auditors provide
much attention to the study and evaluation of both accounting and administrative controls.

A large part of the work of the internal auditor consists of operational audits: however, they may conduct
compliance audit as well. To operate effectively internal auditors must be independent of the line functions in an
organization. However, they cannot be independent of the entity as long as an employer-employee relationship
exists. Making internal auditors directly to the board of directors boost their independence. Users outside the
entity are unlikely to rely on information verified by internal auditors because of their lack of independence.
This lack of independence is the major difference between internal auditors and independent auditors.

The following table provides a comparison of internal and external auditor

Internal Auditor External auditor

An employee of an organization An independent professional service provider
Serves management and the board of Serves third parties who require audited financial
directors information
Reviews all operations and controls the Reviews and reports to the board of directors or
company for accuracy, integrity and shareholders about the fairness of financial
efficiency statements prepared by management.
Directly concerned with the prevention of Incidentally concerned with the prevention of fraud.
fraud in the company’s operations
Independent of the activities audited but Independent of management and the board of directors.
able to respond to the needs of the
management.
Review are conducted periodically in conjunction
Reviews activities continually with the certification of financial statements
Reports on a continual basis to management Reports annually to the board of directors or
and the audit committee shareholders.

Government Auditors: These are auditors employed by federal, regional or local government agencies. At the
federal level, the three primary agencies are the Office of the Auditor General (OAG), The Audit Service
Corporation, and The Federal Inland Revenue Authority. The Office of the Auditor General (OAG) is a federal
organization headed by the Auditor general. This office is responsible for conducting financial statements audit,
compliance audit and operational audit of various federal government offices, before it is submitted to the other
government authorities like the House of the peoples’ representatives. Of course, an increasing portion of the

7|Page
OAG’s audit efforts has been devoted to evaluate the operational efficiency and effectiveness of various
government programs.
The regional governments have also their own regional audit bureau with similar functions. The regional audit
bureaus are primarily responsible to audit the different sectors of the regional government for their operational
efficiency and effectiveness. More over these auditors conduct compliance audit to ensure that the regional offices
are complying with legal requirements.

Federal Inland Revenue Auditors have the responsibility for the enforcement of the tax laws. The major
responsibility of the Inland Revenue Auditors is to audit the returns of tax payers to determine whether they have
complied with the tax laws. These auditors solely perform compliance audits and sometimes are called tax auditors.
Another government organ that performs audit is the Audit Service Corporation. The Audit Service Corporation
audits the financial statements of the public enterprises. Thus the type of audit performed by the Audit service
Corporation is financial statement audit.

8|Page