Chapter 1 Auditing I - 2012

Chapter One
Auditing: An Overview
Learning Objective
 Explain the meaning of Auditing

 Identify the types of audits and auditors
 Explain the need for Auditing
1.1. Auditing Defined
American Accounting Association (AAA), committee on Basic Auditing concepts - defined it

as follows:
Auditing is a systematic process of objectively obtaining and evaluating evidence regarding

assertions/ statements about economic actions and events to ascertain the degree of
correspondence between assertions and established criteria and communicating the results to
interested users.
o Systematic process – this phrase implies there should be a well-planned approach

for conducting an audit. This technique involves objectively obtaining and
evaluating evidence.
o Conducted objectively – this phrase means an audit is conducted with an impartial
mental attitude of the auditor. Auditors should be fair and prejudice or bias shouldn’t
override their objectivity.
o Obtains and evaluates evidence – the auditor should gather sufficient data from
different sources (such as financial statements) and evaluates (tests, inquires, verifies
etc) so as to obtain adequate evidence on the fairness of the statements.
o Assertions about economic actions and events - Assertions are representations
(declarations) made by management about economic activities. For example,
financial statements prepared by management contain numerous assertions. If the
Balance sheet contains amount of Br. 10million for property, plant and equipment,
management is asserting (declaring) that
 Assets exist,
 the company owns the assts,
 the company uses the assets in the production of goods and
services, and
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 this amount represents their un depreciated historical costs etc
o Established criteria –The criteria used for this purpose can be applicable financial
reporting framework such as Generally Accepted Accounting Principles (for financial
statement audit) and local standards – rules, regulations, policies and procedures etc.
o Communicates – lastly, auditor communicates the results to interested Users, via the
type of report the auditor issues.
Distinction between Accounting and Auditing
Accounting is concerned with the collecting (recording, classifying), summarizing, reporting
and interpreting of financial data. Auditing, on the other hand, tests those accounting records
(financial statements) for fairness (appropriateness).
An accountant only needs to know generally accepted accounting principles (GAAP). But,
the auditor needs to know GAAP, plus how to select and evaluate evidence related to the
assertions of financial statements.
Thirdly, accounting is constructive. That

That means, it starts with raw financial data (business
transactions) to process and produce financial statements. However; auditing is analytical i.e.
it starts with financial statement and works to lend credibility on their fairness.
1.2 Types of Audits and Auditors
1.2.1 Types of Audits
Financial Statement Audit: Examination of financial statements so as express opinion on

their fair presentation (whether they are presented fairly in conformity GAAP). Financial
statement audits are reported to whoever user of the statements.
Compliance Audit: To determine whether the company being audited performs in

conformity with certain type of set criteria. For example, management may prescribe
operating procedures such as ʹno overtime work.
The results of compliance audit are, generally, reported to the party who set the criteria.
Operational Audits: Involve a systemic review of organizational activities, or apart of them,

in relation to the efficient and effective use of resources. The purpose of operational audit is
to assess performance, identify areas for improvement, and develop recommendations.
Sometimes this type of audit is referred to as a performance audit or management audit.
audit.
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1.2.2 Types of Auditors
Auditors are individuals/firms who are engaged to audit the economic activities of individuals
and/or organizations. There are three types of Auditors. Those are:
 Independent Auditors
 Internal Auditors, and
 Government Auditors
1.2.2.1. Independent Auditors
Independent auditors, also called external auditors, are either sole practitioners or members
of public accounting firms who render professional auditing services to clients. Independent
auditors work on a fee basis. Most independent auditors are licensed to practice as Certified
Public Accountants (CPA).
1.2.2.2. Internal Auditors
Internal auditors are employees of the entity audited who function in a staff (not in line)
capacity. These types of auditors are involved in an independent appraisal activity within an
organization. Internal auditors assist management of an organization to effectively discharge
their responsibilities.
1.2.2.3 Government Auditors
Auditors employed by different levels of government (federal, state, local etc) are known as
government auditors. In USA, the General Accounting Office (GAO) and the Internal
Revenue Service (IRS) are the primary government auditors.
The GAO is a non- partisan federal agency which is responsible for conducting audit function
for the congress. According to this office, audit refers to examination regarding financial
statements,
statements, compliance with applicable laws and regulations,
regulations, efficiency and economy of
operations, and effectiveness in achieving program results.
The IRS reports are restricted to the tax agency (the Treasury department) and to the tax
payer.
1.3 The Need for Financial Statement Audit
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“why do organizations request for financial statement audit?” this question can be answered
by discussing the following five points:
(i) Control mechanism – Audits are important control mechanisms for

accountability. The auditorsˈ role is determining whether the reports prepared by
management are in conformity with the responsibility and duties provided in the
organization policies.
(ii) To resolve conflict of interest between management and the owners - The
Agency relationship that exists between the owners and managers produces a
natural conflict of interest. Because, the manager has more information about the
ʺTrueʺ financial position and results of operations of the entity than the owner. If
both parties seek to maximize their own self interest, It is likely that the manager
will not act in the best interest of the owners. For example, the manager may
spend organizational funds to provide excessive personal benefits or manipulate
the reported earnings in order to earn a larger bonus. Thus, the need for
Independent (non-partial) opinions or view is necessary to resolve such conflicts.
(iii) To reduce damaging Consequences – Even though, the function of accounting is
to provide information for economic decision making; this information must be
verified by auditors, before they are used for decisions that have serious and
subsequent factual economic consequences.
(iv) To simplify complexity – In our age, financial information & transaction has
been come complex in preparation, content, and format. Therefore it demands
deeply specialized body of knowledge to prepare (compilation), verify and
interpret them.
(v) Regulatory requirements – many business laws, memorandums of association
and government regulation, make requirements’ for annual audits. For Example –
For renewal of license, or permit, (commercial code to Ethiopia), financial
Administration regulation proclamation tax, requires audited financial statements.
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Chapter One

 Explain the meaning of Auditing

American Accounting Association (AAA), committee on Basic Auditing concepts - defined it

Auditing is a systematic process of objectively obtaining and evaluating evidence regarding

o Systematic process – this phrase implies there should be a well-planned approach

Thirdly, accounting is constructive. That

1.2 Types of Audits and Auditors

1.2.1 Types of Audits

Financial Statement Audit: Examination of financial statements so as express opinion on

Compliance Audit: To determine whether the company being audited performs in

Operational Audits: Involve a systemic review of organizational activities, or apart of them,

1.2.2.1. Independent Auditors

1.2.2.2. Internal Auditors

1.2.2.3 Government Auditors

1.3 The Need for Financial Statement Audit

(i) Control mechanism – Audits are important control mechanisms for

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