Auditing Principles and
Practices - I

CHAPTER ONE
INTRODUCTION TO AUDITING
• The historical development of auditing is related to the
development of accounting.
• In the earlier periods, the owners of business can manage
their businesses and the need for independent auditors is
minimal.
• But because of the increase in complexity of business and
different parties interested in achieving their objectives,
the need for an independent auditor is becoming more
important.

Auditing is defined as, the accumulation and evaluation
of evidence about information, to determine and report on
the degree of correspondence between the information
and established criteria.
Whereas, Accounting is the process of identifying,
analyzing, recording, summarizing, and communicating
financial information about a business enterprise for sound
financial decision.

1.1. Historical Development and Evolution of Auditing
The development of auditing is closely related, to the
development of organized systems of accounting.
• The term being derived from the Latin word 'audire,' which
means to 'hear'.
•
Read historcal development of Auditing till 20th century

• These 20th century developments in auditing may be
helpful to you in understanding the direction in which
auditing is moving.
Among them, the most significant developments are
as follows: -
a) A shift in emphasis from the detection of fraud to the
determination of fairness of financial statements.

b) Increased responsibility of the auditors to third parties, such as
governmental agencies, stock exchanges and an investing public.
c)The change of auditing method from detailed examination of
individual transaction, to the use of sampling techniques,
including statistical sampling.
d)Recognition of the need to consider internal control as a guide to
the direction and amount of testing & sampling to be preformed.

e) Development of new auditing procedures applicable to electronic
data processing systems and use of the computer as an auditing tool.
f) Recognition of the need for auditors to find means of protection
from the current wave of litigation.
g) An increased demand for prompt disclosure of both favorable
and unfavorable information concerning any publicly owned
company.
h) Increased concern with compliance by organizations with laws
and regulations.

1.2. Definition and Terminologies of Auditing
• The following are definitions of Auditing, which explain auditing in a
comprehensive manner.
a) In its modern sense, an audit is defined as a process carried out by suitably
qualified auditors whereby the accounting records of the business entity
are subject to inspection in such due as will enable the auditors to form
an opinion as to their truth, fairness and accuracy.
b)Auditing is also described as a process of collection and evaluation of
evidence for the purpose of reporting on economic information.

c) The institute of chartered accountants of India has defined
auditing as "a systematic independent examination of data,
statements, records, operations and performances of an
enterprise for a stated purpose.
d) According to Arens & Loebbecke, auditing is defined as, the
accumulation and evaluation of evidence about information to
determine and report on the degree of correspondence between the
information and established criteria.
• It be done by a competent independent person.

• The description of auditing by Arens and Loebbecke includes several
key terminologies which are important.
Information and established criteria: To do an audit, there must be
information in a verifiable form and some standards [criteria] by which the auditor can
evaluate the information.
Accumulating and evaluating evidence: any information used by the auditor
(oral testimony, written communication and observation).
Competent, independent person: The auditor must be qualified & competent
and must have an independent mental attitude.
Reporting: The final stage in the audit process is the audit report,
which is the communication of the findings to users.

Difference between Auditing and Accounting
Accounting is the recording, classifying and summarizing
economic events in logical manner for the purpose of providing
information for decision making.
In auditing the accounting data, the concern is with determining
whether the recorded information properly reflects the economic
events that occur during the accounting period.

Accounting Auditing of financial statement
 Is the process of identifying ,measuring, recording and
communicating economic information about an
organization in conformity with GAAP/IFRS
 Is the process of obtaining and evaluating evidences
and determining the fairness of financial statement
inconformity with GAAS
 Deliver financial statements to users  Deliver audit report(opinion) to users
 Precede/lead auditing  Begins when accounting ends
 No prescribed qualification is legally required for the
accountant
 The external auditor must be chartered
accountant(CPA)
 All accountant may not have auditing knowledge  Auditors must have accounting knowledge
 An accountant is an employee of the firm  An auditor is independent professional (External)
 Constructive and theoretical  Critical aspect of accounting and analytical in nature
 Accountant are generally appointed by management
and expected to perform according to the rule and
regulation set by management
 An Auditor is appointed by the shareholders’ or audit
committee of the organization and is independent

1.3. Nature, Purpose and Scope of Auditing
Nature of Auditing
Framework of Auditing and Assurance Standards & Guidance
Notes on Related service issued recently, distinguishes audits from
related services.
Related services comprise reviews, agreed-upon procedures and
compilations.
Audits and reviews are designed to enable the auditor to provide
high and moderate levels of assurance respectively, such terms
being used to indicate their comparative ranking.

Assurance in this context refers to the auditor's satisfaction as to
the reliability of an assertion/statement being made by one party
for use by another party.
 To provide such assurance, the auditor assesses the evidence
collected as a result of procedures conducted and expresses a
conclusion.
• Absolute assurance in auditing is not attainable as a result of such
factors as the need for judgment, the use of test checks, the
inherent limitations of any accounting and internal control systems
and the fact that most of the evidence available to the auditor is
persuasive/influential, rather than conclusive, in nature.

Purposes of Auditing
Dependable financial information is essential to the very
existence of the society.
• In making a decision, such as, to buy or sell securities; the
banker deciding to approve a loan; the government to obtain
revenue based on income tax returns etc, all are relying upon
information provided by auditors.

There are many advantages of auditing to the modern
society.
The more important of these are as follows:
A. Tool of Control over Resources
• Auditing is a tool of control over those who harm resources belonging
to others.
• Audit acts as a mere protection against misuse of funds and reduces the
possibility of errors & frauds.

B. Tool for Enhancing Creditability of Economic Information
• The shareholders’ of a company would give greater reliance on
the financial statements of the company, if the auditor expresses
the opinion that these statements present a true and fair view.
C. Tool for Improving Economy and Efficiency
• The auditor reviews the activities of the enterprise. He/she is,
therefore, often in a position to make suggestions to improve the
efficiency of various activities of the enterprise.

Scope of Auditing:
 Scope of Audit is internal and external
The scope of internal audit activity includes examining and
evaluating the policies, procedures and systems which are in place
to ensure: reliability and integrity of information, compliance with
policies, plans, procedures, laws and regulations; safeguarding
assets; economical and efficient use of resources; and
accomplishment of established objectives and goals for operations
or programs.

External audit: is aimed at carrying-out such work as is
necessary to form an opinion as to whether:
a) The accounts are properly kept; and
b) The annual financial statements:
i) are prepared in accordance with the financial records; and
ii) Represent fairly the results of the operations and the financial in
accordance with the Accounting Standards, relevant legislation and
other mandatory professional reporting requirements.

1.5. Types of Audits and Auditors
1.5.1. Types of Audits:
Audits are often classified in to three major types:
1) Audit of Financial Statement
2) Compliance Audit, and
3) Operational Audit /Performance Audit/

1. Audit of Financial Statements
Audit of financial statements is actually part of the
broader concept of the attest/confirm/affirm function.
To attest to financial statements is to provide assurance
as to their fairness and dependability.
The attest function consists of two phases:-
A. The first is the performance of an audit;
B. The second is the issuance of an audit report.

The audit of FSts. ordinarily covers the balance sheet and
the related statements of profit and loss and cash flows.
The goals of audit of FSts. are to determine whether the
statements have been prepared in conformity with GAAP/
IFRS.
FSts. audits are normally performed by certified public
accountants (CPAs).
The contribution of the independent financial audit is to
give credibility to financial statements.

The word “audited” when applied to financial statements means
that; balance sheet, profit and loss statements and cash flows are
accompanied by an audit report prepared by independent
auditors’ expressing their professional opinion as to fairness of
the enterprise's financial statements.

The Objectives of Audit of Financial Statements are:
To determine whether financial statements have been prepared in
accordance to GAAP/IFRS.
To ensure the completeness of financial statements.
To vouch/insure the existence of recorded transactions in the
financial statements.
To examine the accuracy of the financial statements.
To ensure that the net income / loss is the result of the operation
for a given accounting period.
To verify availability of assets recorded in the balance sheet.

2. Compliance Audit
It is dependent upon the existence of verifiable data and of
recognized criteria or standard established by an authoritative
body.
It is an audit to determine whether verifiable data such as
income tax returns or other financial statements are in
conformity with established criteria, for example, laws and
regulations, society has always been concerned with compliance
with laws and regulations by all types of entities, business,
government and non profit making organizations.

The Objectives of Compliance Audits are:
To determine whether there have been violations of laws and
regulations that may have a material effect on the organizations
financial statements.
To provide a basis for additional reports on compliance
procedures that is not tests of the internal control policies and
procedures.
The auditors may discover violations of provisions of laws,
regulations, contracts or grants that result in which they
estimate to be material misstatement to the organization's financial
statements.

3. Operational Audit /Performance Audit/
An operation audit is a systematic independent appraisal
activity within an enterprise, for a review of the entire
departmental performance.
It is to assist all levels of management in the effective
discharges of responsibilities, by furnishing (providing) them
with objective analysis, appraisal, recommendations and
pertinent comments concerning the activities reviewed.
Internal auditors often perform operational audits.

The purpose of an operational audit usually includes the
intention to appraise performance of a particular organizational
function or group of activities.
• The auditors must determine specifically which policies and
procedures are to be appraised and show their relation to the
specific objectives of the enterprise or organization.
Before starting the operational audit, the auditors must obtain a
comprehensive knowledge of the objectives, organizational
structure, and operating characteristics of the unit to be
audited.

Objectives of Operational Audits
The main users of operational audit reports are managers at
various levels.
The management needs the following information:
Assessment of the unit performance in relation to management's
objectives or other appropriate criteria.
Assurance that its plans are comprehensive, consistent and
understood at the operating levels.

Objective information on how well its plans and policies are being
carried out in all areas of operation and opportunities for improvement
in effectiveness, efficiency and economy.
Information on weakness in operating controls, particularly as to
possible sources of waste.
Reassurance that all operating reports can be relied on as basis for
action.

1.5.2. Types of Auditors
Auditors are often viewed as falling into three main types:
A. Independent financial auditor /Certified Public Accountants/
B. Internal auditors
C. Government auditors

A. Independent financial auditors
Independent auditor is a person licensed by the state to practice
public accounting as a profession based on having passed the
uniform CPA examination and having met certain education and
experience.
The most important characteristics of these auditors are a
responsibility to serve the public, of a complex knowledge,
standards of admission to the profession and a need for public
confidence.

It is the report by the independent auditors that gives credibility to a
set of financial statements and makes acceptable to investors,
bankers, government and other users.

B. InternalAuditors
Internal auditing is an independent appraisal activity
established within an organization or enterprise to examine
and evaluate its activities, as a service to the organization in
the effective discharge of their responsibilities.

It is a part of the organization's internal control structure.
They represent high level control that functions by measuring and
evaluating the effectiveness of other internal control policies and
procedures.
It is not merely concerned with the organization's financial controls.
Their work encompasses the entire internal control structure of the
organization or enterprise.
The internal auditing head often accordingly reports to the general
manager or board of directors or president or another high executive.

C. Government Auditors
 A government audit is conducted primarily to ensure that
financial transactions are recorded with proper sanction and
authorization.
In Ethiopia, the office of Auditors General and Office of control
has been given the responsibility to conduct the audit of the
central government and the state governments.

Government auditors examine and make sure that: -
Transactions are correctly recorded and activities conform
to the rules and regulations.
Ensure that public funds are not misused.
Examine the efficiency and effectiveness of selected
projects or program run by government.

Audit Auditors
Internal auditors Independent
Auditors
Government Auditors
Operational
Audit
Primary Nominal Primary
Financial Audit Secondary Primary Nominal
Compliance
Audit
Primary Secondary Primary

END
OF
CHAPTER
ONE