1.

INTRODUCTION TO AUDITING
Introduction
You might have heard of the terms 'Auditing' and 'auditors' many times. What is your knowledge of
the meaning of these terms? What in your understanding does auditor do? When such questions are
put to a group of people the replies would be quite different. Different people have defined auditing in
different ways. Most of these definitions give importance only to some aspects of auditing. In some
cases interestingly some would reply that an auditor is a person who checks the accounts and always
finds fault with what has been done. Some others say that auditing is a process through which frauds
and errors are detected. One would say that an auditor is a person who checks the correctness of
accounts of an enterprise before they were made public. Most of these definitions give importance
only to some aspects of auditing. Let us, however, begin our discussion on the nature of auditing
by the following definitions, 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
where by the accounting records of the business entity are subject to scrutiny 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.
The definitions of auditing above, states that the purpose of auditing is "reporting" by auditors
about economic information. The auditor’s report is the end result of the audit process. The
auditor’s report can be of different kinds. In the case of an audit of balance sheet and profit or
loss account of an enterprise, the auditor expresses his/her opinion on reviewed financial
statement whether the accounts show a true and fair view of the financial position and financial
performance. The nature and scope of the auditor's report in a particular case depends primary on
the terms of engagement and the provision of applicable laws.

1.1 Definition of auditing

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. Auditing should be done by a competent independent person. This description of
auditing includes several key words and phrases. Each of them is discussed in this section
briefly.
 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. Information can and does take many forms. Auditors routinely perform audits of
quantifiable information, including companies’ financial statements and individuals’ federal
income tax returns. Auditors also perform audits of more subjective information, such as the
effectiveness of computer systems and the efficiency of manufacturing operations. The
criteria for evaluating information also vary depending on the information being audited.
 Accumulating and evaluating evidence: Evidence is defined as any information used by
the auditor to determine whether the information being audited is in accordance with the
established criteria. Evidence takes many different forms, including oral testimony of the
audited, written communication with outsiders, and observations by the auditor. It is
important to obtain a sufficient quality and volume of evidence to satisfy the purpose of the
audit.
 Competent, independent person: The auditor must be qualified to understand the criteria
used and competent to know the types and amount of evidence to accumulate to reach the
proper conclusion after the evidence has been examined. The auditor also must have an
independent mental attitude. It does little good to have competent person who is biased
performing the evidence accumulation when unbiased information and objective thinking are
needed for the judgments and decisions to be made.
 Reporting: The final stage in the audit process is the audit report, which is the
communication of the findings to users. Reports differ in nature, but in all cases they must
inform readers of the degree of correspondence between information and established criteria.
Reports also differ in form and can vary from the highly technical type report usually
associated with financial statement audits to a simple oral report in the case of an operational
audit done of a small department’s effectiveness.

1.2 ASSURANCE SERVICES

Assurance services are independent professional services that improve the quality of information
for the decision makers. Individuals who are responsible for making business decisions seek
assurance services to help improve the reliability and relevance of the information used as bases
for their decisions. Assurance services are valued because the assurance provider is independent
and perceived as being unbiased with respect to the information examined.

Assurance services can be performed by many CPAs or by a variety of other professionals. For
example, consumer union is a nonprofit organization that tests a wide variety of products used by
consumers and reports there evaluation of the quality of the products tested in consumer reports.
The information provided in consumer report intended to help consumers make intelligent
decisions about the products they buy. The information provided in consumer reports is
considered more reliable by many consumers then information provided by the manufacturers’
because consumer union is independent of the product manufacturers.

The need for assurance services is not new. CPAs have provided many assurance services for
years, particularly assurance about historical Financial
Statement Information. CPA firms have also performed assurance services related to lotteries
and contests to provide assurance that winners were determine in an unbiased fashion in
accordance with contest rules. More recently, CPAs have been expanding the types of assurance
services they perform to include engagements that provide assurance about other types of
information, such as assurance about company financial forecasts and website controls. The
demand for assurance services are expected to grow as the demand for forward looking
information increases and as more real-time information becomes available through the internet.

1.2.1 Attestation services

One category of assurance services provided by CPAs is attestation services. An attestation
service is a type of assurance service in which the CPA firm issues a report about the reliability
of an assertion that is made by another party. Attestation services fall into five categories:
1. Audit of historical financial statements
2. Audit of internal control over financial reporting
3. Review of historical financial statements
4. Attestation services on information technology
5. Other attestation services that may be applied to a broad range of subject matter

Audit of Historical Financial Statements In an audit of historical financial state - ments,

management asserts that the statements are fairly stated in accordance with applicable country or
international accounting standards. An audit of these statements is a form of attestation service in
which the auditor issues a written report expressing an opinion about whether the financial
statements are fairly stated in accordance with the applicable accounting standards. These audits
are the most common assurance service provided by CPA firms.
Audit of Internal Control over Financial Reporting For an audit of internal control over
financial reporting, management asserts that internal controls have been developed and
implemented following well established criteria. Section 404 of the Sarbanes–Oxley Act requires
public companies to report management’s assessment of the effectiveness of internal control.
The Act also requires auditors to attest to the effectiveness of internal control over financial
reporting. This evaluation, which is integrated with the audit of the financial statements,
increases user confidence about future financial reporting, because effective internal controls
reduce the likelihood of future misstatements in the financial statements.

Review of Historical Financial Statements For a review of historical financial statements,

management asserts that the statements are fairly stated in accordance with accounting standards,
the same as for audits. The CPA provides a lower level of assurance for reviews of financial
statements compared to a high level for audits, therefore less evidence is needed. A review is
often adequate to meet financial statement users’ needs. It can be provided by the CPA firm at a
much lower fee than an audit because less evidence is needed. Many nonpublic companies use
this attestation option to provide limited assurance on their financial statements without incurring
the cost of an audit.

Attestation Services on Information Technology For attestations on information technology,

management makes various assertions about the reliability and security of electronic information.
Many business functions, such as ordering and making payments, are conducted over the Internet
or directly between computers using electronic data interchange (EDI). As transactions and
information are shared online and in real time, businesspeople demand even greater assurances
about information, transactions, and the security protecting them. WebTrust and SysTrust are
examples of attestation services developed to address these assurance needs.

Other Attestation Services CPAs provide numerous other attestation services. Many of these
services are natural extensions of the audit of historical financial statements, as users seek
independent assurances about other types of information. In each case, the organization being
audited must provide an assertion before the CPA can provide the attestation. For example, when
a bank loans money to a company, the loan agreement may require the company to engage a
CPA to provide assurance about the company’s compliance with the financial provisions of the
loan. The company requesting the loan must assert the loan provisions to be attested to before the
CPA can accumulate the evidence needed to issue the attestation report. CPAs can also, for
example, attest to the information in a client’s forecasted financial statements, which are often
used to obtain financing.
1.3 NONASSURANCE SERVICES
CPA firms perform numerous other services that generally fall outside the scope of assurance
services. Three specific examples are:
1. Accounting and bookkeeping services
2. Tax services
3. Management consulting services
Most accounting and bookkeeping services, tax services, and management consulting services
fall outside the scope of assurance services, although there is some common area of overlap
between consulting and assurance services. While the primary purpose of an assurance service is
to improve the quality of information, the primary purpose of a management consulting
engagement is to generate a recommendation to management.
Although the quality of information is often an important criterion in management
consulting, this goal is normally not the primary purpose. For example, a CPA may be engaged
to design and install a new information technology system for a client as a consulting
engagement. The purpose of that engagement is to install the new system, with the goal of
improved information being a by-product of that engagement.
Figure 1-3 reflects the relationship between assurance and non-assurance services.
Audits, reviews, reports on the effectiveness of internal control over financial reporting,
attestation services on information technology, and other attestation services are all examples of
attestation services, which fall under the scope of assurance services. Some assurance services,
such as WebTrust and SysTrust, also meet the criteria of attestation services.
1.4. Types of Audits and Auditors
Audits are often classified in to 3 major types:
 Audit of Financial Statement
 Compliance Audit
 Operational Audits /Performance Audits/
A. Audit of Financial Statement: Audit of financial statements is actually part of the broader
concept of the attest function. To attest to information mean to provide assurance as to fairness
or dependability. Certified Public Accountants (CPAs) attest to a host of other types of
information including the reasonableness of financial forecasts, the adequacy of internal control
and compliance with laws and regulations. To attest to financial statements is to provide
assurance as to their fairness and dependability. The attest function consists of two phases. The
first is the performance of an audit; the second is the issuance of an audit report. The attest
function leads to credibility to management's representations that are contained in the financial
statements.

The audit of financial statements ordinarily covers the balance sheet and the related statements of
profit and loss and cash flows. Financial audit generally is conducted to ascertain whether the
financial statements present true and fair views of the financial position and working results of
an enterprise or organization. The goals of audit of financial statements are to determine whether
the statements have been prepared in conformity with generally accepted accounting principles.
The aim of an independent financial audit is to ascertain if the financial statements of an
enterprise are reliable and dependable. Financial statements audits are normally performed by
certified public accountants.

The contribution of the independent financial audit is to give credibility to financial statements.
Credibility, in this usage means that the financial statements can be believed. That is, they can be
relied upon by outsiders, such as stockholders, creditors, government and other interested third
parties. The objective of an audit of financial statement is to enable the auditor to express an
opinion whether the financial statements are prepared in all material respects in accordance with
an identified financial reporting framework. 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. Financial statements prepared by management
and released to outsiders without first being audited by independent auditors leave a credibility
gap. In addition to the audits of financial statements that we have been discussing, you should be
familiar with compliance audits and operational audits.

2. Compliance Audit: The performance of a compliance audit is dependent upon the

existence of verifiable data and of recognized criteria or standard established by an authoritative
body. Such audits seek to determine whether a tax collection is in compliance with tax laws and
regulations.
Compliance audit is defined, as 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 nonprofit making organizations.
Legislative public officials and the general public want assurance about compliance. Many
governmental entities and non-profit making organizations that receive financial assistance from
banks are subject to periodic compliance audit. Such audits are designed to determine whether
the financial assistance is spent in accordance with applicable laws and regulations.

In auditing the financial statements of the governmental and non-governmental organizations, the
auditors must often perform tests of compliance with laws and regulations to determine that
violations do not have a direct and material effect on financial statements.

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. Such violations are known as material instances of non-compliance. Non-
compliance is the failure to act in accordance with laws or regulations. In these circumstances,
the auditors must consider the effect on their opinion issues on the financial statements. The
resulting misstatement, if left uncorrected, would normally require the auditors to issue a
qualified or adverse opinion. The auditors may also report a description or any indications of
illegal acts that could result in criminal prosecution.

3. Operational and management audit: An operational audit is a systematic independent

appraisal activity within an enterprise for a review of the entire departmental performance as a
service to management. The overall objective of operational auditing is to assist all levels of
management in the effective discharges of responsibilities by furnishing them with objective
analysis, appraisal, recommendations and pertinent comments concerning the activities reviewed.
.
The purpose of an operational audit usually includes the intention to appraise performance of a
particular organizational function or group activities. However, the broad statement must be
expanded to specify precisely the scope of the audit and the nature of the report. 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. This
familiarization process might begin with a study of organizational charts statements of the
function and responsibilities assigned are management polices and directives and operating
polices and procedures.

In attempting to meet, managerial needs operational auditors sample the work performance to see
whether it is in accordance with approved procedures. They verify the accuracy and consistency
of the information obtained in operating reports, and they study the format of the reports to
determine whether the information is presented in a meaningful form. The auditor's
responsibility for seeing that the enterprise's assets are safeguarded against fraud is expanded to a
responsibility for providing protection against all kinds of waste. An enterprise having a strong
system of internal control over its cash, inventory, and other personal property will never suffer a
serious loss from fraud or theft.

Now-a-days economic pressures are forcing companies and government enterprises at all levels
to economize, resulting in an increased demand for the information provided by operational
audits. The demand has been so pronounced that operational auditing has become an extension
of the internal auditing function of most large enterprises. Also governmental auditors engage
extensively in evaluating the economy, effectiveness and efficiency of various government
programs.

1.5 TYPES OF AUDITORS

Auditors are often viewed as falling into three main types
 Independent financial auditor /Certified
Public Accountant/
 Internal auditors
 Government auditors
1. Independent financial auditor: Independent financial auditor or certified public accountant 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.
Including public accounting profession, all of the recognized professions have many common
characteristics. The most important of these characteristics are a responsibility to serve the
public, of a complex knowledge, standards of admission to the profession and a need for public
confidence. To Certified Public Accountants, public confidence is of special significance.
Credibility is the product of the certified public accountants. Without public confidence in the
attester, the attest function serves no useful purpose. To attest to financial statements means to
provide assurance as to their fairness and dependability. The attest function includes, first, the
independent public accountant, must carry out an examination to provide the objective evidence
that enables the auditors to express an informed opinion on the financial statements. Second, the
attest function is the issuance of the auditor's report, which conveys to users of the financial
statements the auditor opinion as to the fairness and dependability of the financial statements.

Reliable financial information is essential to the very existence of society. Thus, good
accounting and audited financial statement aid society in allocation its resources in the most
efficient manner. The goal is to allocate limited resources to the production of those goods and
services for which demand is greatest. Economic resources tend to be attracted to the industries,
and the organizational entities that are shown by accounting measurements to be capable of using
more resources to the best advantage. Inadequate and inappropriate accounting result on the
other hand, conceal waste and inefficiency and thereby prevent resources from being allocated in
a rational manner. 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.

2. Internal Auditors: Although most auditing literatures interest is primarily in the audit of
financial statements by Certified Public Accountants, other professional groups carry on large
scale auditing. These well known types of auditors are internal auditors.
The standard definition adapted by the Institute of Internal Auditors of United States of
America, however is that 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 by furnishing their analysis,
appraisals, recommendations and counsel. In performing these functions internal auditors can be
considered as 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.

Internal auditors are not merely concerned with the organization's financial controls. Their
work encompasses the entire internal control structure of the organization or enterprise. They
evaluate and test the effectiveness of internal control policies and procedures designed to help
the organization or enterprises to meet all of its objectives.
The internal auditing head often accordingly reports to the general manager or board of directors
or president or another high executive. This strategic placement high in the organizational
structure helps assure the internal auditors will have ready access to all units of the business and
that their recommendations will be given prompt attention by department heads. This reporting
standard provides guidance for the head of internal auditing in managing the internal auditing
functions. The head of internal auditing is responsible for properly managing the departments to
help assured that, the audit work is preformed in accordance with professional standards and
fulfills the general purposes and responsibilities developed by management of the organization
and the resources of the internal auditing department are efficiently and effectively employed.

A large part of the internal auditors consists of operational audits in addition; they may conduct
numerous compliance audits. The number and kind of investigative activities varies from year to
year. Unlike the certified public accountants who are committed to verify each significant item
in the annual financial statements the internal auditors are not obliged to repeat their audits in
annual basis.

3. 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 government. Government auditors examine and make 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

1.6 THE NEED FOR FINANCIAL STATEMENT AUDIT

Auditing service are used by government, business and other not for profit organizations. As
societies become more complex, there is an increasing likelihood that unreliable information will
be provided to decision makers. There are several reasons for this: remoteness of information,
biases and motives of provider, Voluminous of data and existence of complex exchange
transactions.
Financial information users, especially external users may need an independent verification of
the fairness of information stated in financial statements. Because there is a likely hood that
unreliable information may be provided to decision makers for reason of

a. Conflict of interest (biases and motives of provider): The information may be biased in favor
of the provider. Such as misstatement of the information

 In a lending decision, to enhance the chance of obtaining loan

 Misstating revenues to attract investors

b. Voluminous data (improperly recorded information): As the entity become larger, so does the
volume of their exchange transaction. This increases the likely hood that improperly recorded
information will be in the report

c. Complex exchange transaction: exchange transaction between entities have become

increasingly complex and hence more difficult to record properly

d. Remoteness of information: when ever information is obtained from others, the likelihood of
it being intentionally or unintentionally misstated is high. In the modern world, it is virtually
impossible for a decision maker to have much firsthand knowledge about the organization
with which he or she does business. Information provided by others must be relied upon.
Whenever information is obtained from others, the likelihood of it being intentionally or
unintentionally misstated is increased

1.7 GENERALLY ACCEPTED AUDITING STANDARD (GAAS)

There are certain basic principles that underlie every audit. An auditor has to ensure
compliance with these principles in carrying out any audit. Therefore, he has to design his
audit procedures and reporting practices in an auditing situation that he can comply with
these basic principles.

Basic principles governing an audit issued by the Institute of Chartered Accountants of USA
that govern an independent audit of financial information are as follows:

A. GENERAL STANDARDS
1. The audit is to be performed by a person or persons having adequate technical training
and proficiency as an auditor.
2. In all matters relating to the assignment, independence in mental attitude is to be
maintained by the auditor or auditors.
3. Due professional care is to be exercised in the planning and performance of the audit and
the preparation of the report.
B. STANDARDS OF FIELD WORK.
4. The work is to be adequately planned and assisted, if any, are to be properly supervised.
5. A sufficient understanding of the internal control is to be obtained to plan the audit and to
determine the nature, timing, and extent of tests to be performed.
6. Sufficient competent evidential matter is to be obtained through inspection, observation,
inquiries, and conformations to afford a reasonable basis for an opinion regarding the
financial statements under audit.

C. STANDARDS OF REPORTING.
7. The report shall state whether the financial statements are presented in accordance with
generally accepted accounting principles.
8. The report shall identify those circumstances in which such principles have been
consistently observed in the current period in relation to the preceding period.
9. Informative disclosures in the financial statements are to be regarded as reasonably
adequate unless otherwise stated in the report.
10. The report shall either contain an expression of opinion regarding the financial
statements, taken as a whole, or an assertion to the effect that an opinion cannot be
expressed; the reasons therefore should be stated. In all cases where an auditor’s name is
associated with financial statements, the report should contain a clear-cut indication of
the character of the auditor’s work, if any, and the degree of responsibility the auditor is
taking.
SUMMARY OF GAAS
GENERAL STANDARDS.
1. Adequate training and proficiency
2. Independence in mental attitude
3. due professional care
STANDARDS OF FIELD WORK
1. Proper planning and supervision
2. Sufficient understanding of internal control
3. Sufficient competent evidence
STANDARDS OF REPORTING
1. Whether statements are prepared in accordance with GAAP
2. Circumstances when GAAP not consistently followed
3. Adequacy of information discloser
4. Expression of opinion on financial statement. General
 UNIT TWO
2. AUDITING PROFESSION AND AUDIT EVIDENCE
The audit function is carried out in complex environment composed of interrelation between the
government, professional organizations, individual auditors, and audit firms. Professional
organizations are interested in audit function because they are issuer of standards. In a similar
fashion, government needs audit function in order to protect the interest of the public and for its
interest too (tax purpose). The function of auditor is to assure financial statements are stated in
accordance with Standards. Reliance on these financial statements can only place if and only if
the auditors perform the audit in an ethical manner i.e. being independent both in appearance and
in fact.
2.1. PROFESSION
A profession is a vocation of the highest standing. It calls on its members to serve the public by
offering to them highly technical and always confidential advise and services, which require a
different standard of conduct from the tradesman. Its members stand in a different relationship
altogether from the man doing ordinary business. Considered in this definition, most criteria for a
profession include a requirement for a professional code of conduct.

2.1.1 Characteristics of Profession

Profession may be defined from various perspectives but is expected to contain basic elements
regardless of whatever perspective it is defined.
Specialized Body of Knowledge

A highly developed profession has a very highly specialized written body of knowledge. The
more the profession is highly developed the more specialized the body of knowledge and,
requiring longer period of time to absorb. The body of knowledge is dynamic and is in constant
development and growth and not static. The body of knowledge here goes far beyond general
educational knowledge.

Standard of qualification of admission

A profession to be a profession must have well- recognized and accepted predetermined criterion
of qualification for admission in to the profession. The standards include educational
requirements as well as other normal and legal criteria fulfillment. The educational requirements
are, composed of theoretical knowledge and practical experience. Usually, the fulfillment of
these requirements is measured through tests of qualifying examinations to prove the
consumption of the accumulated body of knowledge that exists in the profession, and
competence in it.

Standard Conduct of behavior

A profession has standard of conduct of behavior to be observed by the professional through

prescribed code of ethics that attempt to enforce general rule conduct, and maximum and mini
mum rules on competency and responsibility to client and colleagues. Good example of such
code of conduct is the "Oath of Hippocrates" which is sworn by medical doctors at their
graduation.

Level of status recognition Auditing

The quality and level of professional services demanded by society determines the level of status
and recognition to the profession. The level of status and recognition earned in a society is a
function of the quality of professional service rendered which in turn are a function of standard
of professional qualification and the degree of the social, moral and legal responsibility assumed.
The more rigorous are standard of qualification and code of ethics needed for rendering the
professional services, the higher will be the level of status and recognition given to the
profession.

Acceptance of social responsibility and legal liability

A profession to be a Profession must accept responsibility for the consequences of its action. Not
only legal responsibility which arises out of the contractual obligation, but also moral
responsibility to the profession itself and the profession to the society at large. The profession
itself has responsibility to assure the society of the quality of services demanded and accept
sanction for failure to do so.
2.1.2 PROFESSIONAL ETHICS

Broadly defined, the term ethics represents the moral principles or values of conduct recognized
by an individual or group of individuals. Ethics apply when individual has to make decision from
various alternatives regarding moral principles. All societies and individuals possess a sense of
ethics in that they can identify what is "good" or "bad". As C.S. Lewis Observed, "Human beings
all over the earth have some sort of agreement as to what right and wrong are."
 Ethical conduct is determined by each individual. Each person uses moral reasoning to decide
whether something is ethical or not. Ethics are a moral code of conduct that requires an
obligation by us to consider not only ourselves but others. There are a number of ways that
individuals can receive ethical guidance in making moral decisions. Sources for ethical guidance
include our family, friends, religion, and role models.
The purpose of professional ethics in the auditing profession as well as in any other profession is
to build the public confidence, to judge the quality of audit work and means of grounding
guidance of conduct for practitioners.

The advantage of prescribing professional ethics is to emphasize positive activity and encourage
high level of performance while preventing mal-practices. However, there is difficulty in
concretizing them. First, they can only be prescribed in general terms to avoid prescribing
unacceptable behavior, and it's difficult to enforce general ideas of behavior. Second it is difficult
to interpret behavior without reference to specific situation at which point it requires
interpretation of rulings according to circumstances. However, important parts of ethics in
auditing are in relation to:
• Maintenance of mental and physical independence
• General competence and technical standards, and
• Responsibility to client and colleagues
2.1.3 FUNDAMENTAL PRINCIPLES OF AUDITING
In order to achieve the objectives of auditing profession, auditors have to observe a number of
prerequisites or fundamental principles.
The fundamental principles are:
• Integrity: Auditors should be straightforward and honest in performing professional services.
• Objectivity: Auditors should be fair and should not allow prejudice or bias, conflict of interest
or influence of others to override objectivity.
• Professional Competence and Due Care: Auditors should perform professional services with
due care, competence and diligence and has a continuing duty to maintain professional
knowledge and skill at a level required to ensure that a client or employer receives the advantage
of competent professional service based on up-to-date developments in practice, legislation and
techniques.
• Confidentiality: Auditors should respect the confidentiality of information acquired during the
course of performing professional services and should not use or disclose any such information
without proper and specific authority or unless there is a legal or professional right or duty to
disclose it.
• Professional Behavior: Auditors must act in a manner consistent with the good reputation of
the profession and refrain from any conduct which might bring discredit to the profession.
• Technical Standards: Auditors should carry out professional services in accordance with the
relevant technical and professional standards.
Auditors have a duty to carry out with care and skill, the instructions of the client or employer
insofar as they are compatible with the requirements of integrity, objectivity and, in the case of
professional accountants in public practice. In addition, they should conform to the technical and
professional standards promulgated by:
• IFAC (e.g., International Standards on Auditing);
• International Accounting Standards Board;
• The member’s professional body or other regulatory body; and
• Relevant legislation.

2.1.4 LEGAL LIABILITY AND RESPONSIBILITY OF AUDITORS

We are in the era of litigation in which person real or fenced grievances are likely to their
compliances to courts. In this environment, investors and creditors who suffer financial reversal
find auditor as well as attorney and corporate directors tempting target for law suit alleging
professional “mal practice”. Therefore, auditors must approach any engagement with the
prospect that they may be required to defend their work in court. In court of defending legal
action which may be astronomical are not limited to monetary measures. For instance;
• Law suit can be extremely damaging professional reputation which, if once damaged is
difficult to return back.
• The auditor may even be detained criminally for “mal practice”.

Definition of Legal Terms

Discussion of auditor’s liability is best described by defining some of the common terms of the
business law. The following are few to mention
• Ordinary or Simple Negligence: Absence of reasonable care that can be expected of a
person in a set of circumstances. When negligence of an auditor is being evaluated, it is
in terms of what other competent auditors would have done in the same situation.
 • Gross Negligence (also called recklessness or constructive fraud): is a serious
occurrence of negligence tantamount to a flagrant or a reckless departure from the
standard of due care. These terms are frequently used interchangeably and are equivalent
to sloppy auditing or lack of a reasonable basis for a belief. Lack of even slight care in
discharging responsibility.
• Fraud: Knowledge (intentionally) misrepresenting facts to decide the other party and
with the result that the party is injured. It occurs when a CPA issue an opinion on the
financial statement knowing that the financial statements or the audit report thereon is
false.
• Privity of contract: is the relationship between two or more parties that creates
contractual duty. In auditing, context, the CPA and the client have a privity or a
contractual relationship that is usually established by a contract called an engagement
letter.
• An engagement Letter: A written letter contract summarizing contractual relationship
between the auditor and client.
• Breach of Contract: Failure of one or both parties in a contract to fulfill the
requirements of the contract.

2.1.4.1. AUDITORS LEGAL LIABILITY TO CLIENT

The most frequent source of lawsuit against CPAs is from clients. The suits vary widely
including such claims as failure to complete an unaudited engagement on the agreed upon date,
inappropriate withdrawal from an audit, failure to discover a defalcation, and breaching the
confidentiality requirements of CPAs.

A typical lawsuit involves a claim that the auditor did not discover an employee defalcation
(theft of assets) as a result of negligence in the conduct of the audit. The lawsuit can be for
breach of contract, a tort action for negligence, or both. Tort action (wrongful act or damage (not
involving breach of contract) for which an evil action can be brought) can be based on ordinary
negligence, gross negligence or fraud. Tort actions are common because the amounts recoverable
under them are normally larger than under breach of contract.

The principal issue in cases involving alleged negligence is usually the level of care required.
Although it is generally agreed that nobody is perfect, not even a professional, in most instances
any significant error or mistake in judgment will create at least a presumption of negligence that
the professionals will have to rebut. In the auditing environment, failure to meet generally
accepted auditing standard is often conclusive evidence of negligence.

2.1.5 AUDITORS RESPONSIBILITY FOR DETECTING MISSTATEMENTS

The auditors have responsibility to plan and perform the audit to obtain reasonable assurance
about whether the financial statements are free of material misstatement of either caused by error
or fraud.
Reasonable Assurance: Assurance is a measure of level certainty that the auditor has obtained
at the completion of the audit. Reasonable assurance is not defined in the literature, but it is
presume less than certainty or absolute assurance and more than low level of assurance.
Why not absolute assurance?
The fact that auditing is based on sample base, there is no assurance for the absence of
error/fraud in the amounts not included in the sample. The other reason is that, some frauds are
so professionally canceled that the application of GAAS will not reveal it. Hence, with these
limitations the auditor cannot provide absolute assurance.

2.1.6 MATERIALITY AND THE AUDITOR

Materiality is an essential consideration in determining the appropriate type of report for a given
set of circumstances. So what is the concept of materiality? The common definition of
materiality as it applies to accounting and, therefore, to the audit is: A misstatement in the
financial statement can be considered material if knowledge of the misstatement would affect a
decision of a reasonable user of the statement. In applying this definition, three grading of
materiality are used for determining the type of opinion to issue.
Amounts are immaterial : When a misstatement in the financial statements exist, due to of
the two conditions (1) scope restricted by client or by circumstances or (2) statements are not
in accordance with GAAP, but is unlikely to affect the decisions of a reasonable user, it is
considered to be immaterial.
Amounts are material but do not overshadow the financial statement as a whole: The
second level of materiality exists when a misstatement in the financial statement would affect
a users' decision, but the overall statements are still fairly stated, and therefore, useful. For
example, knowledge of a large misstatement in permanent assets might affect a user's
willingness to loan money to a company if the assets were the collateral. A misstatement of
inventory does not mean that cash, accounts receivable, and other elements of the financial
statements, or financial statements as a whole, are materially incorrect.
 Amounts are so material or so pervasive that overall fairness of statements is in
question: The highest level of materiality exists when users are likely to make incorrect
decision if they rely on the overall financial statements.
The auditor's responsibility therefore, is to determine whether financial statements are materially
misstated. If the auditor determines that there is a material misstatement, he/she will bring it to
the client's attention so a correction can be made. If the client refuses to correct the statements, a
qualified or adverse opinion must be issued, depending on how material the misstatement is.
Auditors must, therefore, have a thorough knowledge of the application of materiality.

2.1.6.1 Factors Affecting Materiality Judgment

Several factors affect setting a preliminary judgment about materiality for a given set of financial
statements. The most important of these are:
Materiality is a relative rather than absolute concept: A misstatement of a given magnitude
might be material for a small company, whereas, the same birr amount error could be immaterial
for a large one. Hence, it is not possible to establish any birr- value guidelines for a preliminary
judgment about materiality applicable to all audit clients.
Bases are needed for evaluating materiality: since materiality is relative, it is necessary to
have base for establishing whether misstatements are material. Net income before taxation is
normally the most important base for deciding what material is because it is regarded as a critical
item of information for users. It is also important to learn whether the misstatements could
materially affect the reasonableness of other possible base such as current assets, current
liabilities, and owners' equity.
Qualitative factors also affect materiality: certain types of misstatements are likely to be more
important to users than others, even if the birr amounts are the same. For example:
• Amounts involving irregularities are usually considered more important than unintentional
errors of equal dollar amounts because irregularities reflect on the honesty and reliability of
the management or other personnel involved.
• Errors that are otherwise minor may be material if there are possible consequences arising
from contractual obligations.
• Errors that are otherwise immaterial may be material if they affect a trend in earnings. For
example, if reported income has increased 3 percent annually for the past five years, but
income for the current year has declined 1 percent, that change of trend may be material.
Similarly, an error that could cause a loss to be reported as a profit would be of concern.
2.1.7 ERROR AND FRAUD

Error – An error represents an unintentional misstatement of the financial statement. It may be

material or immaterial.
• Mistake in gathering and reporting data
• Mistake in application of GAAP
• Unintentional omission of amount
• Informative disclosure on financial statement.

Fraud: Fraud represents an intentional misstatement of the financial statement which can be
material or immaterial. The misstatement due to fraud may occur due to either of:
• Misappropriation of assets defalcations or employee fraud. E.g. theft of cash or another
asset.
• Fraudulent financial reporting often called management fraud. E.g. intentional misstatement
of sales near the balance sheet date to increase reported earnings.

2.1.8 TRUTH AND FAIRNESS

The term truth and fairness are essential elements of audit report. There is no statutory or
professional definition of truth and fairness. Truth and fair is a technical in the phrase to be
looked at as entirely. In general, the word "true" means, information is factual confirms to
reality, not false. The information confirms with standards.
Fairness means; clear distinct and plain
• Impartial, not biased or
• Just and equitable
To show true and fairness accounts must be prepared
• In accordance with GAAP
• On constant basis so as not to be misleading
• The accounts must be taken from books and records.

2.1.9 CLIENT ACCEPTANCE PROCEDURE

Auditing is a time-sensitive and risk-intensive business. Financial controversy and fraud has
raised the bar on auditing firm diligence. A critical step in an auditing firm establishing strong
credentials and minimizing risk is obtaining clients that are dependable, financially secure and
present a low risk for fraud. The most successful audit client acceptance procedures reduce legal
and financial risk by accepting only companies with strong operating and financial track records.
Hence the auditor should review the following points.

Prior Audit Review: Review the reasons why a company is looking for a new auditor. It may
be the company is performing due diligence and looking for a lower cost option for audit
reviews, or the company may be a new firm that has just increased revenues to the point where it
needs an audit. Likewise, a company may be looking for a new firm because it has run into
conflicts with prior auditors. Conflicts could include audit procedures the company did not like
or payment problems. A former auditing firm may have dropped the company for failing to
comply with audit requests or for routine late payments. As an auditing firm, you should decide
how much risk you are willing to take with a company that has an unreliable auditing past.

Ratings and Public Records: The financial ratings and public records of a company should
be reviewed before an audit client is accepted. Review credit reports, legal history, tax problems,
litigation records, regulatory actions, bankruptcy issues, consumer complaints and professional
liability claims. Require the company to provide business references for review. A solid review
of a company's professional and public dealings will provide good insight into the stability and
functioning of the company.

Reputation: Your reputation as an auditing firm is partly based on the companies you audit.
Ensure the image of your auditing firm by only accepting clients who share the same ethical and
business integrity foundation as your firm. Interview senior management and executives to gain
an understanding of their business principles. Look into the background of the key players in the
business for any criminal or legal problems and at their personal reputation in the business
community. Determine if the company pays their bills on time and honors contracts and
agreements. Avoid any client that has a long history of litigations as a defendant or as a plaintiff.

Business Structure: Review the business structure of a potential client. Look for red flags
such as overseas plants or operating facilities, high turnover in upper management and a short
operating history. Also review the company's legal counsel to see if they a have stable, well-
known legal firm, or unknown or shady representation. Review the company's physical business
presence. How long a business has stayed in the same location is an indication of stability.
2.2 Audit Report

The Auditor's report is a formal opinion, or disclaimer thereof, issued by either an internal auditor or an
independent external auditor as a result of an internal or external audit or evaluation performed on a legal
entity or subdivision thereof (called an “auditee”). Reports are essential to audit and assurance
engagement, because they communicate the auditor’s findings. Users of financial statement rely on the
auditor’s report to provide assurance on the company’s financial statement. The auditor is held
responsible if an incorrect audit report is issued. The audit report is the final step in the entire audit
process. The reason for studying it now is to permit reference to different audit reports as evidence
accumulation and audit procedures are studied in this and second part of auditing.

This unit is divided in to four subunits. The first subunit deals with the basic components of audit report.
The second subunit discusses the five kinds of audit opinions. The third subunit discusses about
materiality and audit opinion. The last subunit winds up the discussion by presenting about auditors
decision process for audit report.

2.2.1 Components of Audit Report

To enable users understand audit report, professional standards provide uniform wording for auditor’s
report. An audit report has to contain a minimum of the following seven parts.

1. Report title: - Auditing standard requires that the report be titled and that the title include the word
“independent”. For example, appropriate title would be “independent auditors report”, “report of
independent auditors”, or “independent accountant’s opinion”. The requirement that the title includes the
word independent is intended to convey to users that the audit was unbiased in all aspects.

2. Audit Report Address: - the report is usually addressed to the company, its stockholders or board of
directors. In recent years, it has become customary to address the report to stockholders to indicate that
the auditor is independent of the company and the board of directors.

3. word “independent”.: - The first paragraph of the report does three things:-

1. It makes a simple statement that CPA firm has conducted an audit to distinguish it from review or
compilation.
2. It state financial statements that were audited in the wordings given by management together
with exact dates or periods
 3. It shows that the statements are the responsibilities of managers and the auditors work is to give
an opinion to indicate that the selection of GAAP is up to managers.

4. Scope Paragraph: - The scope paragraph is a factual statement about what the auditor did in the audit.
This paragraph first states that the auditor followed generally accepted auditing standards. The remainder
briefly describes important aspects of an audit. The scope paragraph states that the audit is designed to
obtain reasonable assurance about whether the statements are free of material misstatement. The inclusion
of the word material conveys that the auditor is responsible only to reach for significant misstatements not
minor misstatements that do not affect users’ decision. The use of the term reasonable assurance is
intended to indicate that an audit cannot be expected to completely eliminate the possibility that a
material misstatement will exist in the financial statement. In other words, an audit provides a high level
of assurances, but it is not a guarantee.

The remainder of the scope paragraph discusses the audit evidence accumulated and states that the auditor
believes that the evidence accumulated was appropriate for the circumstance to express the opinion
presented. The word test basis indicates that sampling is used rather than an audit of every transaction and
amount on the statement. The scope paragraph states that the auditor evaluates the appropriateness of
those accounting principles, estimates and financial statements disclosures and presentations given.

5. Opinion Paragraph: The final paragraph in the standard report states the auditors conclusions based
on the results of the audit. This part of the report is so important that often the entire audit report is
referred to simply as the auditor’s opinion. The opinion paragraph is stated as an opinion rather than as a
statement of absolute fact or a guarantee. The intent is to indicate that the conclusions are based on
professional judgment. The phrase in our opinion indicates that may be some information risk associated
with the financial statement, even though the statements have been audited.

The opinion paragraph is directly related to the first and the fourth generally accepted auditing reporting
standards. The auditor is required to state an opinion about financial statement taken as a whole, including
the conclusion about whether the company followed Generally Accepted Accounting Principles.
Financial statements are presented fairly when the statements are in accordance with generally accepted
accounting principles but that it is also necessary to examine the substance of transactions and balances
for possible misinformation.

6. Name of CPA Firm: the name identifies the CPA firm or practitioner who performed the audit.
Typically, the firm’s name is used because the entire CPA firm has the legal and professional
responsibility to ensure that the quality of the audit meets professional standards.

7. Audit Report Date: The appropriate date for the report is one on which the auditor has completed the
most important auditing procedures in the field. This date is important to users because it indicates the
last date of the auditor’s responsibility for the review of significant events that occurred after the date of
financial statements. For example, if the balance sheet is dated December 31, 1998, and the audit report is
dated March 6, 1999. This indicates that the auditor has searched for material unrecorded transactions and
events that occurred up to March 6, 1999. If the auditor searched only until the financial statement date,
the audit report date should be December 31, 1998

2.2.2 Kinds of Audit Opinion

There are five common types of auditor’s reports, each one presenting a different situation encountered
during the auditor’s work.

1. Standard Unqualified Opinion Report

2. Unqualified opinion with explanatory paragraph or modified wording
3. Qualified opinion Report
4. Adverse Opinion Report
5. Disclaimer of opinion Report
These different types of audit reports will be discussed in detail in the following sub units

2.2.2.1 Standard Unqualified Audit Report

This type of report is issued by an auditor when the financial statements presented are free from material
misstatements and are presented fairly in accordance with the Generally Accepted Accounting Principles
(GAAP), which in other words means that the company’s financial condition, position, and operations are
fairly presented in the financial statements. It is the best type of report an auditee may receive from an
external auditor. The standard unqualified audit report is sometimes called a clean opinion, because there
are no circumstances requiring a qualification or modification of the auditor’s opinion. The standard
unqualified report is the most common audit opinion. Sometimes, circumstances beyond the client
auditor’s control prevent the issuance of a clean opinion. However, in most cases, companies make the
appropriate changes to their accounting records to avoid a qualification or modification by the auditor.
The standard unqualified audit report is issued when the following conditions have been met:

1. All statements- balance sheet, income statements or retained earnings and statements of cash
flow-are included in the financial statement.
2. The three general standards have been followed in all respects on the engagement
3. Sufficient evidence has been accumulated, and the auditor has conducted the engagement in a
manner that enables him or her to conclude that the three standards of filed work have been met.
4. The financial statements are presented in accordance with Generally Accepted Accounting
Principles. This also means that adequate disclosures have been included in the footnotes and
other parts of the financial statements.
 5. There are no circumstances requiring the additions of an explanatory paragraph or modification
of the wording of the report.
If any of the five requirements for the standard unqualified audit report are not met, the standard
unqualified report cannot be issued.

The following is an example of a standard unqualified auditor’s report on financial statements as

it is used in most countries, using the name ABC Company as an auditee’s name:

INDEPENDENT AUDITOR’S REPORT

To: Stockholders
ABC Company, Inc.

We have audited the accompanying financial statement of ABC Company, Inc. as of December
31, 2009 and the related statements of income, retained earnings, Balance sheet and cash flows
for the year then ended. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial statements based on
our audit.

We conducted our audit in accordance with auditing standards generally accepted in (the
country where the report is issued). Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free from material
misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a reasonable basis for our
opinion.

In our opinion, the financial statements referred to above presents fairly, in all material respects,
the financial position of the Company as of December 31, 2009, and the results of its operations
and its cash flows for the year then ended in accordance with accounting principles generally
accepted in (the country where the report is issued).
AUDITOR’S SIGNATURE
Auditor’s name and address

Date of completion of the major field work

2.2.2.2 Unqualified Audit Report with Explanatory Paragraph or Modified

Wording

In certain situation, an unqualified audit report is issued, but the wording deviates from the standard
unqualified report. The unqualified audit report with explanatory paragraph or modified wording meets
the criteria of a complete audit with satisfactory results and financial statements that are fairly presented,
but the auditor believes it is important or is required to provide additional information. The followings are
the most important causes of the addition of an explanatory paragraph or a modification in the wording of
the standard unqualified report.

1. Lack of consistent Application of GAAP

The second reporting standard requires the auditor to call attention to circumstances in which accounting
principles have not been consistently observed in the current period in relation to the preceding period.
Generally Accepted Accounting Principles require that change in accounting principles or their method of
application is to a preferable principle that the nature and impact of the change be adequately disclosed.
When a material change occurs, the auditor should modify the report by adding an explanatory paragraph
after the opinion paragraph that discusses the nature of the change and points the reader to the footnotes
that discusses the change. An explanatory paragraph is required for both voluntary changes and required
changes due to a new accounting pronouncement

Explanatory paragraph because of change in accounting principles

Independent auditor’s opinion

(Same introductory, scope, and opinion paragraph as the standard report)

As discussed in the note to the financial statements, the company changed its method of computing
depreciation in 2009.
It is implicit in the explanatory paragraph in the above table that, the auditor agrees with the
appropriateness of the change in accounting principles. If the auditor does not so agree, the change is
considered a violation of Generally Accepted Accounting and his or her opinion must be different

2. Consistency versus Comparability

The auditor must be able to distinguish between changes that affect consistency and those that may affect
comparability but don’t affect consistency. The following are examples of changes that affect consistency
and therefore require explanatory paragraph if they are material

 Change in accounting principles, such as change from FIFO to LIFO inventory valuation
 Changes in reporting entities, such as the inclusion of an additional company in combined
financial statements
 Correction of errors involving principles, by changing from an accounting principle that is not
generally acceptable to one that is generally acceptable, including correction of the resulting error
Changes that affect comparability but not consistency and therefore need not be included in the audit
report include the following

 Changes in estimates, such as a decrease in the life of an asset for depreciation purposes
 Error corrections not involving principles such as a previous years mathematical error
 Variation in format and presentation of finical information
 Changes because of substantially different transactions or events, such as new endeavors in
research and development or the sales of subsidiary.
Items that materially affect the comparability of financial statements generally require disclosure in the
footnotes. A qualified audit report for inadequate disclosure may be required if the client refuses to
properly disclose the items

3. Substantial Doubt about Going Concern

Even though the purpose of an audit is not to evaluate the financial health of the business, the auditor has
a responsibility to evaluate whether the company is likely to continue as a going concern. For example,
the existence of one or more of the following factors causes uncertainty about the ability of a company to
continue as a going concern:

 Significant recurring operating losses or working capital deficiencies

 Inability of the company to pay its obligation as they come due
  Loss of major customers, the occurrence of uninsured catastrophes such as an earthquake or
flood, or unusual labor difficulties
 Legal proceedings, legislation, or similar matters that have occurred that might jeopardize the
entity’s ability to operate

When the auditor concluded that there is substantial doubt about the entity’s ability to continue as a going
concern, unqualified opinion with an explanatory paragraph is required, regardless of the disclosure in the
financial statement. The following table provides an example in which there is substantial doubt about
going concern.

Independent auditor’s opinion

(Same introductory, scope, and opinion paragraph as the standard report)

The accompanying financial statements have been prepared assuming that ABC Company continues as
going concern. As the discussion in the note to the financial statements, ABC Company has suffered
recurring losses from operations and has a net capital deficiency that raises substantial doubt about the
company’s ability to continue as a going concern. Management’s plan in regard to these matters are also
described in the note. The financial statements don’t include any adjustments that might result from the
outcomes of this uncertainty.

4. Auditors Agrees with a Departure from a Promulgated Principle

Sometimes the company’s departure from Generally Accepted Principles is acceptable, if adhering to the
principles would have produced a misleading result. In this case, the auditor can issue Standard
unqualified audit report with additional explanation for the change.

5. Emphasis of Matter

Under certain circumstance, the auditor may want to emphasis specific matters regarding the financial
statements even though he or she intends to express an unqualified opinion. Normally, such explanatory
information should be included in a separate paragraph in the report. The followings are examples of
explanatory information the auditor may think should be expressed: existence of significant related party
transactions, important events occurring subsequent to the balance sheet date, the description of
accounting matters affecting the comparability of the financial statements with those of the preceding
year and material uncertainties disclosed in the footnotes.
6. Reports involving Other Auditors

When an auditor relies on different auditors to perform part of the audit, which is common when the
client has several widespread branches or subdivisions, the principal audit firm has three alternatives.
Only the second one is an unqualified report with modified wording

1. Make no reference in the audit report: when no reference is made to the other auditor, a
standard unqualified opinion is given unless other circumstances require a departure. This
paragraph is typically followed when the other auditor audited an immaterial portion of the
statement, the other auditor is well known or closely supervised by the principal auditor, or the
principal auditor has thoroughly reviewed the other auditor’s work. The other auditor is still
responsible for his or her own report and work in the event of lawsuit.
2. Make reference in the report: This type of report is called a shared opinion or report. A shared
unqualified report is appropriate when it is impractical to review the work of the other auditor or
when the portion of the financial statements audited by the other CPA is material in relation to the
whole.
3. Qualify the opinion: the principal auditor may conclude that a qualified opinion is required.
A qualified opinion or disclaimer, depending on the materiality is required if the principal auditor
is not willing to assume any responsibility for the work of the other auditor. The principal auditor
may also decide that a qualification is required in the overall report if the other auditor qualified
his or her portion of the audit. Qualified opinion and disclaimers are discussed in the next
subunit.

2.2.2.3 Qualified, Adverse and Disclaimer Audit Reports

There are circumstances where the conditions of unqualified audit report are not satisfied. When these
conditions are not satisfied, the auditor issues an opinion other than unqualified audit report. The three
conditions requiring departure from unqualified audit report are

1. The scope of the audit has been restricted: when the auditor has not accumulated sufficient evidence
to conclude whether financial statements are stated in accordance with GAAP, scope restriction exists.
The scope restrictions can be caused by the client or circumstances beyond the client or the auditor. An
example of client restriction is management’s refusal to permit the auditor to confirm material receivables
or to physically examine inventory. An example of restriction caused by circumstances is when the
engagement is not agreed on until after the client year end. It may not be possible to physically observe
inventories, confirm receivables or perform other important procedures after the balance sheet date
2. Financial statements have not been prepared in accordance with generally accepted accounting
principles. For example, if the client insists on using replacement costs for fixed or value inventory at
selling price rather than historical cost, departure form unqualified report is required.

3. The auditor is not independent: when any of the rules of the code of professional conduct related to
independence you have discussed in unit two are violated, the auditor is said to be dependent

When any of the three conditions requiring a departure from unqualified report exists and is material, a
report other than unqualified report must be issued. Three main types of audit reports are issued under this
condition:: Qualified, Adverse opinion, and Disclaimer of opinion.

1. Qualified Opinion Report

A Qualified Opinion report is issued when the auditor encountered one of the two types of situations
which do not comply with generally accepted accounting principles, however, the rest of the financial
statements are fairly presented. This type of opinion is very similar to an unqualified or “clean opinion”,
but the report states that the financial statements are fairly presented with a certain exception which is
otherwise misstated. The two types of situations which would cause an auditor to issue this opinion over
the unqualified opinion are:

 Deviation from GAAP – this type of qualification occurs when one or more areas of the
financial statements do not conform with GAAP (e.g. are misstated), but do not affect the rest of
the financial statements from being fairly presented when taken as a whole. Examples of this
include a company dedicated to a retail business that did not correctly calculate the depreciation
expense of its building. Even if this expense is considered material, since the rest of the financial
statements do conform with GAAP, then the auditor qualifies the opinion by describing the
depreciation misstatement in the report and continues to issue a clean opinion on the rest of the
financial statements.

 Limitation of Scope - this type of qualification occurs when the auditor could not audit one or
more areas of the financial statements, and although they could not be verified, the rest of the
financial statements were audited and they conform with GAAP. Examples of this include an
auditor not being able to observe and test a company’s inventory of goods. If the auditor audited
the rest of the financial statements and is reasonably sure that they conform with GAAP, then the
 auditor simply states that the financial statements are fairly presented, with the exception of the
inventory which could not be audited.

The wording of the qualified report is very similar to the unqualified opinion, but an explanatory
paragraph is added to explain the reasons for the qualification after the scope paragraph but before the
opinion paragraph. The introductory paragraph is left exactly the same as in the unqualified opinion,
while the scope and the opinion paragraphs receive a slight modification in line with the qualification in
the explanatory paragraph.

The scope paragraph is edited to include the following phrase in the first sentence, so that the user may be
immediately aware of the qualification. This placement also informs the user that, except for the
qualification, the rest of the audit was performed without qualifications:

“Except as discussed in the following paragraph, we conducted our audit...”

The opinion paragraph is also edited to include an additional phrase in the first sentence, so that the user
is reminded that the auditor’s opinion explicitly excludes the qualification expressed. Depending on the
type of qualification, the phrase is edited to either state the qualification and the adjustments needed to
correct it or state the scope limitation and that adjustment could have but not necessarily been required in
order to correct it.

For a qualification arising from a deviation from GAAP, the following phrase is added to the opinion
paragraph, using the depreciation example mentioned above:

“In our opinion, except for the effects of the Company’s incorrect determination of depreciation
expense, the financial statement referred to in the first paragraph presents fairly, in all material
respects, the financial position of…”

For a qualification arising from a scope limitation, the following phrase is added to the opinion paragraph,
using the inventory example mentioned above:
 “In our opinion, except for the effects of such adjustments, if any, as might have been determined
to be necessary had we been able to perform proper tests and procedures on the Company’s
inventory, the financial statement referred to in the first paragraph presents fairly, in all material
respects, the financial position of…”

Due to the phrases added to the scope and opinion paragraphs, many refer to this report as the Except-For
Opinion.

2. Adverse Opinion Report

An Adverse Opinion is issued when the auditor determines that the financial statements of an auditee are
materially misstated and, when considered as a whole, do not conform to GAAP. It is considered the
opposite of an unqualified or clean opinion, essentially stating that the information contained is materially
incorrect, unreliable, and inaccurate in order to assess the auditee’s financial position and results of
operations. Investors, lending institutions, and governments very rarely accept an auditee’s financial
statements if the auditor issued an adverse opinion, and usually request the auditee to correct the financial
statements and obtain another audit report.

Generally, an adverse opinion is only given if the financial statement pervasively differs from GAAP. An
example of such a situation would be failure of a company to consolidate a material subsidiary.

The wording of the adverse report is similar to the qualified report. The scope paragraph is modified
accordingly and an explanatory paragraph is added to explain the reason for the adverse opinion after the
scope paragraph but before the opinion paragraph. However, the most significant change in the adverse
report from the qualified report is in the opinion paragraph, where the auditor clearly states that the
financial statements are not in accordance with GAAP, which means that they, as a whole, are unreliable,
inaccurate, and do not present a fair view of the auditee’s position and operations.

“In our opinion, because of the situations mentioned above (in the explanatory paragraph),
the financial statements referred to in the first paragraph do not present fairly, in all material
respects, the financial position of…”
3. Disclaimer of Opinion Report

A Disclaimer of Opinion, commonly referred to simply as a Disclaimer, is issued when the auditor could
not form, and consequently refuses to present, an opinion on the financial statements. This type of report
is issued when the auditor tried to audit an entity but could not complete the work due to various reasons
and does not issue an opinion.

Auditing Standards provide certain situations where a disclaimer of opinion may be appropriate:

 A lack of independence, or material conflict(s) of interest, exist between the auditor and the
auditee
 There are significant scope limitations, whether intentional or not, which hinder the auditor’s
work in obtaining evidence and performing procedures
 There is a substantial doubt about the auditee’s ability to continue as a going concern or, in other
words, continue operating
 There are significant uncertainties within the auditee

Although this type of opinion is rarely used, the most common examples where disclaimers are issued
include audits where the auditee willfully hides or refuses to provide evidence and information to the
auditor in significant areas of the financial statements, where the auditee is facing significant legal and
litigation issues in which the outcome is uncertain (usually government investigations), and where the
auditee has going concern issues (the auditee may not continue operating in the near future). Investors,
lending institutions, and governments typically reject an auditee’s financial statements if the auditor
disclaimed an opinion, and will request the auditee to correct the situations the auditor mentioned and
obtain another audit report.

A disclaimer of opinion differs substantially from the rest of the auditor’s report because it provides very
little information regarding the audit itself, and includes an explanatory paragraph stating the reasons for
the disclaimer. Although, the report still contains the letterhead, the auditee’s name and address, the
auditor’s signature and address, and the report’s issuance date, every other paragraph is modified
extensively, and the scope paragraph is entirely omitted since the auditor is basically stating that an audit
could not be realized.

In the introductory paragraph, the first phrase changes from “We have audited” to “We were engaged to
audit” in order to let the user know that the auditee commissioned an audit, but does not mention that the
auditor necessarily completed the audit. Additionally, since the audit was not completely and/or
adequately performed, the auditor refuses to accept any responsibility by omitting the last sentence of the
paragraph. The scope paragraph is omitted in its entirety since, effectively, no audit was performed.
Similar to the qualified and the adverse opinions, the auditor must briefly discuss the situations for the
disclaimer in an explanatory paragraph. Finally, the opinion paragraph changes completely, stating that an
opinion could not be formed and is not expressed because of the situations mentioned in the previous
paragraphs. The following is a draft of the three main paragraphs of a disclaimer of opinion because of
inadequate accounting records of an auditee, which is considered a significant scope limitation:

We were engaged to audit the accompanying balance sheet of ABC Company, Inc. (the
“Company”) as of December 31, 2009 and the related statements of income and cash flows for
the year then ended. These financial statements are the responsibility of the Company's
management.

The Company does not maintain adequate accounting records to provide sufficient information
for the preparation of the basic financial statements. The Company’s accounting records do not
constitute a double-entry system which can produce financial statements.

Because of the significance of the matters discussed in the preceding paragraphs, the scope of
our work was not sufficient to enable us to express, and we do not express, an opinion of the
financial statements referred to in the first paragraph.

2.2.2.4 Materiality and Audit Report

A misstatement in the financial statements can be consider material if knowledge of the misstatement
would affect a decision of a reasonable user of the statements. Materiality is an essential consideration in
determining the appropriate types of report for a given set of circumstances. For example, if a
misstatement is immaterial relative to the financial statements of the entity for the current period, it is
appropriate to issue an unqualified report. A common instance is the immediate expensing of office
supplies rather than carrying the unused portion in inventory because the amount is significant. The
situation is totally different when the amounts are of such significant that the financial statements are
materially affected as a whole. In these circumstances, it is necessary to issue a disclaimer of opinion or
an adverse opinion, depending on the nature of the misstatement. In situation of lesser materiality a
qualified opinion is appropriate.
Three levels of materiality are used for determining the type of opinion to issue

1. Amounts are Immaterial: When a misstatement in the financial statement exists but is unlikely
to affect the decision of a reasonable user, it is considered to be immaterial. Unqualified opinion
is therefore appropriate. For example, assume that management recorded unexpired insurance as
an asset in the previous year and decides to expense it in the current year to reduce record keeping
costs; management has failed to follow GAAP but if the amounts are small, the misstatement
would be immaterial and standard unqualified audit report would be appropriate.
2. Amounts are material but don’t overshadow the financial statements as a whole: The second
level of materiality exists when a misstatement in the financial statement would affect a user’s
decision but the overall statements are still fairly stated and therefore useful. For example,
knowledge of a large misstatement in fixed assets might affect a user’s willingness to loan money
to a company if the asset were the collateral. When the auditor concludes that a misstatement is
material but doesn’t overshadow the financial statements as a whole, a qualified opinion using
except for is appropriate.
3. Amounts are so material or so pervasive that overall fairness of the statements is in
question. The highest level of materiality exists when users are likely to make incorrect decisions
if they rely on the overall financial statements when the highest level of materiality exists, the
auditor must issue either a disclaimer of opinion or an adverse opinion, depending on which
conditions exist.

The following table summarizes the relationship between materiality and type of opinion issued

Materiality level

Significance in terms of reasonable user decision Type of opinion

Immaterial users decisions are unlikely to be affected Unqualified

User’s decisions are likely to be affected only if the

information in question is important to the specific
decisions being made. The overall financial
Material statement are presented fairly Qualified

Most or all users decision based on the financial Disclaimer or

Highly material statements are likely to be significantly affected Adverse
2.2.2.5 Auditor’s Decision Process for Audit Reports
Auditors use a well-defined process for deciding the appropriate audit report in a given set of
circumstances. The followings are steps followed:

1. Determine whether any condition exists requiring a departure from a standard

unqualified report: Auditors identify conditions as they perform the audit and include
information about any condition in the working paper as discussion items for audit reporting.
If non of these conditions exists, which is the case in most audits, the auditor issue a standard
unqualified audit report.
2. Decide the materiality for each condition: when a condition requiring a departure from a
standard unqualified opinion exists, the auditor evaluates the potential effect on the financial
statements. For departure from GAAP or scope restriction, the auditor decides among
immaterial, material, and highly material. All other conditions, except for lack of auditor’s
independence, require only a distinction between immaterial and material. The materiality
decision is a difficult one requiring considerable judgment. For example, assume that there is
a scope limitation in auditing inventory. It is difficult to assess the potential misstatement of
an account that the auditor doesn’t audit.
3. Decide the appropriate type of report for the condition, given the materiality level: After
making the first two decisions, it is easy to decide the appropriate type of opinion by using a
decision aid. The following table is an example for such an aid

Conditions requiring an unqualified Level of Materiality

report with modified wording or
explanatory paragraph Immaterial Material

Accounting Principles not consistently Unqualified with explanatory

applied Unqualified paragraph

Unqualified with explanatory

Doubt about Going concern Unqualified paragraph

Unqualified with explanatory

Departure from GAAP Unqualified paragraph

Unqualified with explanatory

Emphasis of matter Unqualified paragraph

Use of another auditor Unqualified Unqualified with modified

 wording

Level of Materiality

Conditions requiring departure from Material but not Material and

unqualified report Immaterial overshadow overshadow

Scope restricted by client or conditions Unqualified Qualified Disclaimer

Financial statements not prepared in

accordance with GAAP Unqualified Qualified Adverse

The auditor is not independent - Disclaimer -

Auditors often encounter situations involving more than one of the conditions requiring a departure from
an unqualified report or modification of the standard unqualified report. In this circumstance, the auditor
should modify his or her opinion for each condition unless one has the effect of neutralizing the others.
For example, if there is a scope limitation and a situation in which the auditor is not independent, the
scope limitation should not be revealed. The following situations are examples when more than one
modification should be included in the report:

 The auditor is not independent and the auditor know that the company has not followed GAAP
 There is a scope limitation and there is substantial doubt about the company’s ability to continue as
a going concern
 There is a substantial doubt about the company’s ability to continue as going concern, and
information about the cause of uncertainty is not adequately disclosed in a footnote
 There is a deviation in the statements preparation in accordance with GAAP and other accounting
principles was applied on a basis that was not consistent with that of the preceding year.

4. Write the Audit Report

Many readers interpret the number of paragraphs in the report as an important signal as to whether the
financial statements are correct. A three paragraph report originally indicates that there are no exceptions
in the audit. However, three paragraph reports are also issued when a disclaimer of opinion is issued due
to a scope limitation or for an unqualified shared report involving other auditors. More than three
paragraphs indicate some type of qualification or requiring explanation. The table below summarizes the
type of reports issued for the audit of financial statements, the number of paragraphs for each type, the
standard wording, paragraph modified, and the location of additional paragraph.

Number of Standard wording paragraph Location of additional

Type of report paragraph modified paragraph

Standard
Unqualified Three None None

Unqualified with
Explanatory Four None After opinion

Qualified Four Opinion only Before opinion

Introductory and opinion

Disclaimer Three paragraph modified Before opinion

Adverse Four Opinion only Before opinion

UNIT THREE

3. AUDIT RESPONSIBILITIES AND OBJECTIVES

 Explain the objective of conducting an audit of statements and an audit of internal
controls.

Objective of Conducting an Audit of Financial Statements: The objective of the ordinary audit
of financial statements is the expression of an opinion of the fairness with which they present
fairly, in all respects, financial position, result of operations, and its cash flows in conformity
with GAAP.

3.1 Steps to Develop Audit Objectives:

1. Understand objectives and responsibilities for the audit.

2. Divide financial statements into cycles.
3. Know management assertions about accounts.
4. Know general audit objectives for classes of transactions and accounts.
5. Know specific audit objectives for classes of transactions and accounts.

Distinguish management’s responsibility for the financial statements and internal

control from the auditor’s responsibility for verifying the financial statements and
effectiveness of internal control.

Management’s Responsibilities: Management is responsible for the financial statements and for
internal control. The Sarbanes–Oxley Act increases management’s responsibility for the financial
statements. It requires the CEO and the CFO of public companies to certify the quarterly and annual
financial statements submitted to the SEC. The Sarbanes-Oxley Act provides for criminal penalties
for anyone who knowingly falsely certifies the statements.

Explain the auditor’s responsibility for discovering material misstatements.

Auditor’s Responsibilities:

Material versus immaterial misstatements

Reasonable assurance
Errors versus fraud
Professional skepticism
Fraud resulting from fraudulent financial reporting versus misappropriation of assets

Auditor’s Responsibilities for Discovering Illegal Acts:

Direct-effect illegal acts

Indirect-effect illegal acts
 Classify transactions and account balances into financial statement cycles and identify
benefits of a cycle approach to segmenting the audit.

Financial Statements Cycles: Audits are performed by dividing the financial statements into smaller
segments or components.
 Describe why the auditor obtains a combination of assurance by auditing class of
transactions and ending balances in accounts.

Distinguish among the five categories of management assertions about financial

information.

Financial Statement Assertions

What does the management telling us when it prepares and provides financial statement to us?

Assertions are expressed or implied representation by the management that are reflected in the financial
statement components. For example, when the balance sheet contains account receivable of Br. 5 million,
management asserts that receivables exist and have a net realizable value of Br. 5 million. Management
also asserts that the account receivable balances arose from selling goods or services on credit in the
normal course of the business. In general, the assertions relates to the requirements of GAAP. These
assertions are parts of the criteria management uses to record and disclose accounting information in
financial statements. Auditors must there for understand the assertions to adequately audit. That is to
confirm client’s financial statements to GAAP. Auditing standard classifies assertions in to five
categories.

1. Existence or Occurrence Assertion: these deals with whether transactions recorded in journal or
balances in the ledger have actually occurred during a given period and whether assets or liabilities of the
entity actually exist at a given date. For example, management asserts that inventory shown on the
balance sheet physically exists and is available for sales. Similarly, management asserts that revenue
reported in the income statement represents valid sales that occurred during the period

2. Completeness: assertion about completeness address whether all transactions and accounts that should
be presented in the financial statement are included. For example, management asserts that inventory
represent all items on hand at the balance sheet date. Managements also implicitly asserts that the amount
shown for account payable on the balance sheet includes all such liabilities on the balance sheet date

3. Right and Obligation: assertion about rights and obligation address whether assets are the rights to the
entity and liabilities are obligations of the entity at a given date. For example, management asserts that the
entity has legal title or rights of ownership to the inventory shown on the balance. Similarly amounts
capitalized for lease reflects assertions that the entity has right to leased property and that the
corresponding lease labiality represents an obligation of the entity.

4. Valuation or Allocation: assertions about valuation and allocation address whether assets, liabilities,
equities, revenue and expense components have been included in the financial statements at appropriate
amount. For example, management asserts that inventory is carried at the lower of cost or market value on
the balance sheet date. Similarly, managements assert that the cost of property, plants and equipments is
systematically allocated to appropriate accounting periods by recognizing depreciation expense.

5. Presentation and Disclosure: assertion about presentation and disclosure address whether particular
components of financial statements are properly classified, described and disclosed. For example,
management asserts that the portion of long term debt shown as current liability will mature in the current
year. Similarly, managements assert, through footnote disclosure that all major restriction on the entity
resulting from debt covenants is disclosed.

Link the six general transaction- related audit objectives to the five management assertions.
Audit Objectives

What are the objectives of the auditor when she/he accepts the audit engagement of a company?
In obtaining evidence to support the assertion contained in the financial statements, the auditor develops
audit objectives that relates to each management assertion. Audit objectives tests the assertions contained
in the components of financial statements. These objectives are both general and specific audit objectives.
Once the auditor has sufficient evidence that the set audit objectives are met, he or she has reasonable
assurance that the financial statement is fairly stated. The following section discusses the general and
specific audit objectives in more detail.

1. Validity: the validity objective relates to the existence or occurrence assertion and is concerned with
whether the transactions included in the account are valid or that they exist. The auditor’s main concern is
that the account balances are not overstated due to fictitious amounts. For example, to test the validity of
account receivable, the auditor might confirm the customers balance. A customer’s acknowledgment that
the amount is owed provides evidence on the validity of the recorded accounts receivable.

2. Completeness: the completeness objective relates to the management assertion of completeness and
address whether all transaction are included in the account. For example, if the client fails to record sales
or purchase transaction, the financial statement will be misstated. Note that, the auditor’s concern with
completeness is opposite to the concern for validity. Failure to meet the completeness objective results in
an understating an account, while invalid recorded amount results in an account being overstated. For
example, to test the completeness objectives for accounts receivable, the auditor compares the total of the
accounts receivable subsidiary ledger to the account receivable control account in the general ledger. If
the totals do not agree, some sales transactions and the related account receivables may not have included
in the clients accounting records.

3.Cutoff: the cutoff objectives is primarily related to the completeness assertion and is concerned with
whether the transaction included in the account, if valid are recorded in the proper period. The audit
procedure must ensure that transactions occurring near the year end are recorded in the financial
statement in the proper period.

4. Ownership: this objective addresses whether the asset and liability belong to the entity and relates to
management’s assertion about right and obligation. If the entity does not have rights to an asset, or if a
liability is not the entity’s obligation, it should not be included in the financial statements.

5. Accuracy: the accuracy objective relates to the valuation or allocation assertion and addresses proper
accumulation of transaction and amounts from journals and ledgers. For example, auditors frequently use
aged trail balances to document the detailed in accounts receivable subsidiary ledger. To test the aged trail
balance accuracy, the auditors foot the aged trail balances and traces selected customer accounts from the
aged trail balances to the account receivable subsidiary ledger for proper amount and aging

6. Valuation: the valuation objective relates to the valuation or allocation assertion and is concerned with
ensuring that the account shown in the financial statements are recorded at the proper amount. Generally
accepted accounting principles establish the valuation method for a particular transaction or account
balance. For example, account receivable are accounted for at net realizable value; that is, the allowance
for doubtful accounts is used to adjust gross account receivable to the balance excepted to be collected.
The auditor tests the adequacy of the allowance for uncollectible accounts by examining the entities past
bad debt experience relatives to the current balance in the allowance account.

7. Detail Tie In: Account balances on financial statements are supported by details in master files and
schedules prepared by clients. The detail tie in objective is concerned that the details on lists are
accurately prepared, correctly added and agree with the general ledger. For example, individual accounts
receivables on a listing of accounts receivable should be the same in the accounts receivable master file
and the total should equal the general ledger control account.

8. Classification: it is important that transaction be included in the correct account and the account is
properly presented in the financial statements. For example, in auditing accounts receivable, the auditor
examines the listing of account receivables to ensure that receivables from affiliates, officers, directors, or
other related parties are classified separately from trade receivables. The classification objectives relates
to the presentation and disclosure assertions.

9. Disclosure: This audit objective relates directly to the presentation and disclosure assertion and is
concerned with ensuring that all required financial statements and footnote disclosures are made. For
example, if account receivables are pledged as security for debt, such information should be disclosed in
the financial statements. Similarly, if a long term debt agreement contains major covenant (such as limits
on payments of dividend or issuance of additional debt), that information should be disclosed.

The following table shows management assertions, general audit objectives and specific audit objectives
for inventory.

Link the nine general balance- related audit objectives to the five management assertions.
Management General Specific Audit Objective
Assertion Objective

Existence or Validity All recorded inventory exist at the balance sheet date
Occurrence

Completeness Completeness All existing inventory has been included in the account

Rights and Obligations Ownership The company has title to all inventory items listed

Valuation or Valuation Inventory quantity agrees with items physical on hand

Allocation
Price used to value inventory are correct

classification Inventory items are properly classified to raw material,

work in process and finished goods

Cutoff Purchase and sales cut off at the end is proper

Detail tie in Total of inventory items agree with general ledger

Accuracy Inventory quantity on clients perpetual record agree with

items physically on hand

Presentation and Disclosure The pledge and consignment of inventory is disclosed

Disclosure

Explain the relationship between audit objectives and the accumulation of audit
evidence.

How Audit Objectives Are Met: The auditor must obtain sufficient competent audit evidence to

support all management assertions in the financial statements. An audit process is a methodology

for organizing an audit.

 UNIT FOUR

4. AUDIT EVIDENCE

Introduction

The foundation of any audit is the evidence gathered and evaluated by the auditor. The auditor must have
the knowledge and skill to accumulate sufficient and competent evidence to every audit to meet the
standards of profession. This chapter deals with the types of evidence decisions auditor make, the
evidence available to auditors, and the use of that evidence in performing an audit.

4.1. Nature of Evidence

Audit evidence is any information used by the auditor to determine whether the information being audited
is stated in accordance with the established criteria. The information varies greatly in the extent to which
it persuades the auditor whether the financial statements are stated in accordance with Generally
Accepted Accounting Principles. Evidence includes information that is highly persuasive, such as the
auditor's count of marketable securities, and less persuasive information, such as response to questions of
client employees.

4.2. The Audit Evidence Decision

A major decision facing every auditor is determining the appropriate types and amounts of evidence to
accumulate to be satisfied that the components of the client's financial statements are fairly stated. This
judgment is important because of the prohibitive cost of examining and evaluating all available evidence.
For example, in an audit of financial statement, of most organizations, it is impossible for CPA firm to
examine the contents of all computer files or available evidence such as cancelled checks, vendors'
invoices, customer orders, payroll time cards, and the many other types of documents and orders. The
auditor's decision on evidence accumulation can be broken down into the following four sub decisions.

1) Which audit procedure to use

2) What sample size to select for a given procedure
3) Which items to select from the population
4) When to perform the procedure
1. Audit Procedure: an audit procedure is the detailed instruction for the collection of audit evidence that is
to obtain at some time during the audit. In designing audit procedures, it is common to spell them out in
 sufficiently specific to permit their use as instructions during the audit. For example, the following is an
audit procedure for the verification of cash disbursements:
 Obtain the cash disbursements journal and compare the payer name, amount, and date on the
cancelled checks with the disbursements journal
2. Sample size: Once an audit procedure is selected, it is possible to vary the sample size from one to all the
items in the population being tested. In the audit procedure above, suppose 6,600 checks are recorded in the
cash disbursement journal. The auditor may select a sample size of 200 checks for comparison with the cash
disbursement journal. The decision of how many items to test must be made by the auditor for each audit
procedure. The sample size for any given procedure is likely to vary from audit to audit.
3. Items to select: After the sample size has been determined for an audit procedure, it is still necessary to
decide which items in the population to test. If the auditor decides, for example, to select 200 cancelled
checks from population of 6,600 for comparison with the cash disbursement journal, several deferent
methods can be used to select the specific checks to be examined. The auditor could (1) select a week and
examine the first 200 checks (2) select the 200 checks with the largest amounts, (3) select the checks
randomly, or (4) select those checks that the auditor thinks are most likely to be in error. Or a combination
of these methods could be used.
4. Timing: Auditor of financial statements usually covers a period such as a year, and an audit is usually not
completed until several weeks or months after the end of the period. The timing of audit procedures can
therefore vary from early in the accounting period to long after it has ended. In part, the timing decision is
affected by when the client needs the audit to be completed.

Activity
1. Define the audit evidence

2. Describe the four basic audit evidence decisions

4.3. Persuasiveness of Evidence

The third standard of fieldwork requires the auditor to accumulate sufficient and competent evidence to
support the opinion issue. Because of the nature of the audit evidence and the cost consideration of doing
an audit, it is unlikely that the auditor will be completely convinced that the opinion is correct. However,
the auditor must be persuaded that his/her opinion is correct with a high level of assurance. By
combining all evidence from the entire audit, the auditor is able to decide when he/she is persuaded to
issue and audit report.

The two determines of the persuasiveness of evidence are Competence and sufficiency, which are taken
directly from the third standard of fieldwork.
4.3.1. Competence: Competence of evidence refers to the degree to which evidence can be considered
believable or worthy of trust. If evidence is considered highly competent, it is a great help in persuading
the auditor that financial statements are fairly stated. For example, if an auditor counted the inventory,
that evidence would be more competent than if management gave the auditor its own figure. In most
cases, the term reliability of evidence is being used synonymously with competence.

Competence of evidence deals only with the audit procedures selected. Competence cannot be improved
by selecting a larger sample size or different population items. It can be improved only by selecting audit
procedures that contain a higher quality of one or more of the following seven characteristics of the
competent evidence: Relevance, independence of provider, effectiveness of client's internal control,
auditor's direct knowledge, qualification of individuals proving the information, degree of objectivity, and
timeliness.

1. Relevance: Evidence must pertain to or be relevant to the audit objective that the auditor is testing
before it can be reliable. For example, assume that the auditor is concerned that a client is failing to bill
customers for shipments (completeness objective). If the auditor selected a sample of duplicate sales
invoices and traced each to related shipping document s, the evidence would not be relevant for the
completeness objective and therefore, would not be considered reliable evidence for that objective. A
relevant procedure would be to trace a sample of shipping documents to related duplicate sales invoice to
determine whether each had been billed. The second audit procedure is relevant and the first is not
because the shipment of goods is the normal criterion used for determining whether a sale has occurred
and should have billed. By tracing from shipping, documents to duplicate sales invoices, the auditor can
determine whether shipment have been billed to customers. When the auditor traces from duplicated sales
invoices, to shipping documents, it is impossible to find unbilled shipments. Relevance can be considered
only in terms of specific audit objectives. Evidence may be relevant to one audit objective but not to a
different one.

1. Independence of provider: Evidence obtained from a source outside the entity is more reliable than
that obtained from within. For example, external evidence such as communication from banks,
attorneys, or customers is generally considered more reliable than answers obtained from inquiries of
the client. Similarly, documents that originate from outside the client's organization are considered
more reliable than are those that originate within the company and have never left the client's
organization.
2. Effectiveness of client's internal control: When a client's internal controls are effective, evidence
obtained is more reliable than when they are weak. For example, if internal control over sales and
bills are effective, the auditor could obtain more competent evidence from sales invoices and shipping
documents than if the controls were independent.

3. Auditor's direct knowledge: Evidence obtained directly by the auditor through physical
examination, observation, computation, and inspection is more competent than information obtained
indirectly. For example, if the auditor calculates the gross margin as a percentage of sales and
compares it with previous periods, the evidence would be more reliable than if the auditor relied on
the calculations of the controller.

4. Qualification of individuals providing the information: Although the source of information is

independent, the evidence will not be reliable unless the individual providing it is qualified to do so.
Therefore, communications from attorneys and bank confirmations are typically more highly
regarded than accounts receivable, confirmations from persons not familiar with the business world.
Also, evidence obtained directly by the auditor may not be reliable if he/she lacks the qualification to
evaluate the evidence.

5. Degree of Objectivity: Objective evidence is more reliable than evidence that requires considerable
judgment to determine whether it is correct. Examples, of objective evidence includes confirmation of
accounts receivables and bank balances, the physical count of securities and cash, and adding
(footing) a list of accounts payable to determine whether it agrees with the balance in the general
ledger. Example of subjective evidence include a letter written by clients attorneys discussing the
likely outcome of outstanding lawsuit against the client, observation obsolescence of inventory during
physical examination, and inquires of the credit manager about the collectability of non current
account receivable when the reliability of subjective evidence is began evaluated, the qualification of
the person providing the evidence are important.
6. Timeliness: The timeliness of audit evidence can refer either to when it is accumulated or to the
period covered by the audit. Evidence is usually more reliable for balance sheet accounts when it is
obtained as close to the balance sheet date as possible. For example, the auditor's count of marketable
securities on the balance sheet date would be more reliable than the count two months earlier. For
income statement accounts, evidence is more reliable if there is a sample from the entire period under
audit rather than from only a part of the period.

4.3.2. Sufficiency: The quantity of evidence obtained determines its sufficiency. Sufficiency of evidence
is measured primarily by the sample size the auditor selects. For a given audit procedure, the evidence
obtained from a sample size of 200 would ordinarily be more sufficient than from a sample of 100.
Several factors determine the appropriate sample size in audit.

The two most important ones are:

1. The auditor's expectation of misstatement

2. Effectiveness of internal control
If the auditor concludes that there is a high likelihood of obsolete inventory because of the nature of the
client's industry, the auditor would sample more inventories for obsolescence in an audit such as this than
one where the likelihood of obsolescence was low. Similarly, if the auditor concludes that the client's
internal control is effective, over fixed assets, a smaller sample size in the audit of acquisition of fixed
assets is warranted.

In addition to sample size, the individual items tested affect the sufficiency of evidence. Samples
containing population items with larger dollar values, items with a large likelihood of misstatement, and
items that are representative of the population are usually considered sufficient. In contrast, most auditors
would usually consider samples insufficient that contain only the largest dollar items from the population
unless these items make up a large portion of the total population amount.

Persuasiveness of evidence can be evaluated only after considering the combination of competence and
sufficiency, including the effects of the factors influencing competence and sufficiency. A large sample of
evidence provided by an independent party is not persuasive unless it is relevant to the audit objective
being tested. A large sample of evidence that is relevant but not objective is not persuasive. Similarly, a
small sample of only one or two piece of highly competent evidence also typically lacks persuasiveness.
The auditor must evaluate the degree to which both competence and sufficiency, including all factors
influencing them, have been met when determining the persuasiveness of evidence.

Persuasiveness and cost: in making decisions about evidence for a given audit, both persuasiveness and
cost must be considered. It is rare when only one type of evidence is available for varying information.
The persuasiveness and cost of all alternatives should be considered before selecting the best type. The
auditor's goal is to obtain a sufficient amount of competent evidence at the lowest possible total cost.
However, cost is never an adequate justification for omitting a necessary procedure or not gathering
sample size.

4.4. Types of Audit Evidence

In making which audit procedures to use, the auditor can choose from seven broad categories of evidence.
These categories, called types of evidence, are listed below and defines are discussed in this section.

1. Physical examination 2, Confirmation 3, Documentation

4, Observation 5, Inquiry of the client 6, Re-performance 7, Analytical Procedure
4.4.1. Physical Examination: Is the inspection or count by the auditor of tangible assets. This type of
evidence is most often associated with inventory and cash, but it is also applicable to the verification of
securities, notes receivable, and tangible fixed assets. The distinction between the physical examination of
assets, such as marketable securities and cash, and the examination of documents such cancelled checks
and sales documents, is important for auditing purpose. If the object being examined; such as a sales
invoices, has no inherent value, the evidence is called documentation. For example, before check is
signed, it is documented; after it is signed, it becomes an asset; and when it is cancelled, it becomes a
document again. Typically, physical examination of the checks can occur only while the check is an asset.
Physical examination, which is a direct means of verifying that an assets actually exists (existence
objective), is regarded as one of the most reliable and useful types of audit evidence. Generally, physical
examination is an objective means of ascertaining both the quality and the description of the assets. In
some case, it is also a useful method for evaluating an asset's condition or quality. However, physical
examination is not sufficient evidence to verify that existing assets are owned by the client (rights and
obligations objective), and in many cases the auditor is not qualified to judge qualitative factors such as
obsolescence or authenticity (net realizable value objective). Also, proper valuation for financial
statement purpose usually cannot be determined by physical examination (accuracy objective).

4.4.2. Confirmation: Describes the receipt of a written or oral response from an independent third party
verifying the accuracy of information that was required by the auditor. The request is made to the client,
and the client asks the independent third party to respond directly to the auditor. Because the confirmation
comes from sources independent of client, they are a highly regarded and often used type of evidence.
However, confirmations are relatively costly to obtain and may cause some inconvenience to those asked
to supply them. Therefore, they are not used in every instance in which they are applicable. Because of
the high reliability of confirmations, auditors typically obtain written response rather than oral ones when
it is practical. Written confirmations are easier for supervisors to review, and they provide better support
if it is necessary to demonstrate that a confirmation was received.

Whether or not confirmations should be used depends on the reliability needs of the situation as well as
the alternative evidence available. Traditionally, confirmations are seldom used in the audit of fixed asset
additions because these can be verified adequately by documentation and physical examination.
Similarly, confirmations are ordinarily not used to verify individual transactions between the
organizations, such as sales transactions, such as sale transactions, because the auditor can use documents
for that purpose.
4.4.3. Documentation: Documentation is the auditor's examination of the client's documents and records
to substantiate the information that is or should be included in the financial statements. The documents
examined by the auditor are the records used by the client to provide information for conducting its
business in an organized manner. Because each transaction in the client's organization is normally
supported by at least one document, there is a large volume of this type of evidence available. For
example, the client often retains a customer order, a shipment document, and duplicate sales invoices for
each sales transaction. These same documents are useful evidence for verification by the auditor of the
accuracy of the client's records for sales transaction. Documentation is form evidence widely used in
every audit because it is usually readily available to the auditors at a relatively lower cost. Sometimes it is
the only reasonable type of evidence available.

Documents can be conveniently classified as internal and external.

An internal documents is one that has been prepared and used within the client's organization and is
retained without ever going to outside party such as a customer or a vendor. Examples of internal
documents include duplicate sales invoices, employees' time reports, and inventory receiving reports.

An external document is one that has been in the hands of some one outside the client's organization who
is a party to the transaction being documented, but which is either currently in the hands of the client or
readily accessible. Example of this type of external documents vendors' invoices, cancelable notes
payable and insurance policies.

The primary determinants of the auditor's willingness to accept a document as reliable evidence is
whether it is internal or external and, when internal, whether it was created and processed under condition
of good internal control . Internal documents created and processed under condition of weak internal
control may not constitute reliable evidence.

Because external documents have been in the hands of both the client and another party to the transaction,
there is some indication that both members are in agreement about the information and the condition
stated on the documents. Therefore, external documents are considered more reliable evidence than
internal once.

When auditors use documentation to support recorded transactions or amounts it is often called Vouching.
4.4.4. Observation: Is the use of the senses to assess certain activities. Throughout the audit, there are
many opportunities to exercise sight, hearing, touch, and smell to evaluate a wide range of items. For
example, the auditor may tour the plant to obtain a general impression of the client's facilities,
observe whether equipment is rusty to evaluate whether it is obsolete, and which watch individuals
perform accounting tasks to determine whether the person assigned responsibility is performing it.
Observation is rarely sufficient by itself because, there is a risk that the client personnel involved in
those activities are aware of the auditor's presence. Therefore, they may perform their responsibilities
in accordance with company policy, but resume normal activities once the auditor is not incite.

4.4.5. Inquiries of the client: Inquiry is the obtaining of written or oral information from the client in
response to questions from the auditor. Although considerable evidence is obtained from the client
through inquiry, it usually cannot be regarded conclusive because it is not from an independent source
and may be biased in the client's favor. Therefore, when the auditor obtains evidence through inquiry,
it is normally necessary to obtain further corroborating evidence though other procedures.

4.4.6. Re-performance: As the word implies, re-performance involves rechecking a sample of the
computations and transfer of information made by the client during the period under audit.
Rechecking of computation consists of testing the client's arithmetical accuracy. It includes such
procedures as extending sales invoices and inventory, adding journals and subsidiary records, and
checking the calculation of depreciation expense and prepaid expenses. Rechecking of transparence
of information consists of tracing amounts to be confident that when the same information is included
in more than one place, it is recorded at the same amount each time.

4.4.7Analytical Procedures: Analytical procedures are defined by SAS (AU 329) as evaluations of
financial information made by a study of relationships among financial and non-financial
data…..involving comparisons of recorded amounts to expressions developed by auditors. It uses
comparisons and relationships to assess whether account balances or other data appears reasonable. An
example is comparing the gross margin percent in the current year with the preceding years. The auditing
standard board has concluded that analytical procedures are so important that they required during the
planning and completion phase on all audit.
Importance of Analytical Procedures

1. Enable to understand client's industry and business

Generally, an auditor considers knowledge and experience about a client company obtained in prior years
as a starting point for planning the audit for the current year. By conducting analytical procedures in
which the current year's unaudited information is compared with prior years' audited information, changes
are highlighted. The changes represent important trends or specific events, all of which will influence
audit planning.

For example, a decline in gross margin percentages overtime may indicate increasing competition in the
company's market area, and the need to consider inventory pricing more carefully during the audit.
Similarly, an increase in the balance in fixed assets may indicate a significant acquisition that must be
reviewed.

2. Enable to assess the entity's ability to continue as going concern

Analytical procedures are often useful as an indication that the client company encountering severe
financial difficulty. The likelihood of financial failure must be considered by the auditor in the assessment
of audit related risks, as well as in connection with management's use of the ongoing concern assumptions
in preparing the financial statements. For example, if a higher than normal ratio of long-term debt to net
worth is combined with a lower than average ratio, of profits to total assets, a relatively high risk of
financial failure may be indicated. Not only would such condition affect the audit plan, they may indicate
that substantial doubt exists about the entity's ability to continue as going concern, which could require a
report modification.

3. It indicates the presence of possible misstatement in the financial statements

Significant unexpected difference between the current year's unaudited financial data and other data used
in comparisons are commonly called unusual fluctuations. Unusual fluctuations occur when significant
difference are not expected but do exist or when significant differences are expected but do not exist. In
either case, one of the possible reasons for unusual fluctuations is the presence of an accounting
misstatement. Thus, if the unusual fluctuation is large, the auditor must determine the reason for it and
must be satisfied that the cause is a valid economic event and not a misstatement. For example, in
comparing the ratio of the allowance for uncollectible accounts receivable to gross accounts receivable,
with that of the previous year, suppose that the ratio had decreased while, at the same time, accounts
receivable turnover also decreased. The combination of these two pieces of information would indicate a
possible understatement of the allowance. This aspect of analytical process is often called attention
directing because it results in more detailed procedures in the specific audit areas where misstatements
might be found.

4. Reduced Detailed audit test: When the analytical procedure reveals no unusual fluctuations, the
implication is that the possibility of a material misstatement is minimized. In that case, the analytical
procedure constitutes substantive evidence in support of the fair statement of the related account balances,
and it is possible to perform fewer detailed tests in connection with those accounts.