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Learning Objectives

 Explain the general nature of auditing, and its


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.

Auditing part I By: Yetnayet Ayele, AAUSC, 2015 3


 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

Auditing part I By: Yetnayet Ayele, AAUSC, 2012 5


…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).

Auditing part I By: Yetnayet Ayele, AAUSC, 2012 6


…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

Auditing part I By: Yetnayet Ayele, AAUSC, 2015 9


 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.

Auditing part I By: Yetnayet Ayele, AAUSC, 2015 11


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.

Auditing part I By: Yetnayet Ayele, AAUSC, 2015 13


 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.

Auditing part I By: Yetnayet Ayele, AAUSC, 2015 14


 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

Auditing part I By: Yetnayet Ayele, AAUSC, 2015 15


 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

Auditing part I By: Yetnayet Ayele, AAUSC, 2015 16


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.

Auditing part I By: Yetnayet Ayele, AAUSC, 2012 18


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)

Auditing part I By: Yetnayet Ayele, AAUSC, 2012 19


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.
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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.
-

Auditing part I By: Yetnayet Ayele, AAUSC, 2012 23


…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.

Auditing part I By: Yetnayet Ayele, AAUSC, 2012 24


 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.

Auditing part I By: Yetnayet Ayele, AAUSC, 2015 26


…… 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”.

Auditing part I By: Yetnayet Ayele, AAUSC, 2015 27


…… 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

Auditing part I By: Yetnayet Ayele, AAUSC, 2015 29


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.
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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).

Auditing part I By: Yetnayet Ayele, AAUSC, 2015 35


 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

Auditing part I By: Yetnayet Ayele, AAUSC, 2015 37


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

Auditing part I By: Yetnayet Ayele, AAUSC, 2015 38


 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.
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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

Auditing part I By: Yetnayet Ayele, AAUSC, 2015 43


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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 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)
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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

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