Chapter-one

1 INTRODUCTION -AN OVERVIEW OF AUDITING

1.1 Historical Background of Auditing Practices

 Generally, the early historical development of auditing is not well documented.

 Auditing in the form of ancient checking activities was found in the ancient civilizations of China,
Egypt and Greece.

 The ancient checking activities found in Greece (around 350 B.C.) appear to be closest to the
present-day auditing.

 During this period, every single public officer must account for everything given to them. Anyone
against whom they prove embezzlement is convicted and fined by the court ten times the sum
discovered stolen.

The word ‘audit’ was derived from the Latin word ‘audire’ meaning “to hear”, “listen” or “give credence
to”.

Ever since control and accountability for money was entrusted to third parties it becomes necessary to
account for the transactions and subject them to some sort of an independent checking.

1.2 Definition of Auditing

A 1973 study by the American Accounting Association entitled, “A Statement of Basic Auditing Concepts,
defined auditing as, ‘a systematic process of objectively obtaining and evaluating evidence regarding
assertions about economic actions and events to ascertain the degree of correspondence between
these assertions and established criteria and communicating the results to interested users’.

From the definition we can understand the following concepts:-

 An audit is a systematic approach- By systematic we mean that all audits follow certain steps,
namely (1) planning, (2) fieldwork, and (3) reporting. The audit follows a structured,
documented plan (audit plan) whereby objectives are set and audit programs are developed
that guide the field work. The audit must be planed and structured in such a way that those
carrying out the audit can fully examine and analyze all important evidence. In the fieldwork of
the audit, accounting records are analyzed by the auditors using a variety of generally accepted
techniques. Finally, results are developed in to reports and communicated with users.

 An audit is conducted objectively –an audit is an independent, objective and expert examination
and evaluation of evidence. Auditors are faire and do not allow prejudice or bias to override
their objective. They maintain an impartial attitude.
 The auditor obtains and evaluates evidence – the auditor assesses the reliability and sufficiency
of the information contained .in the underlying accounting records and other source data by:

a) Studying and evaluating accounting system and internal control on which he wishes
to relay and testing internal controls to determine the nature, extent and timing of
other auditing procedure ;and

b) Carrying out such other testes, inquiries and other verification procedure of
accounting transaction and account balances as he considers appropriate in the
particular circumstances.

 The evidence obtained and evaluated by the auditor concerns assertions about economic
actions and events. Assertions are representations by management, explicit or otherwise, that
are embodied in the financial statements. One assertion of management about economic
actions is that all the assets reported on the balance sheet actually exist at the balance sheet
date. The assets are real, not fictitious. This is the existence assertion. Furthermore,
management asserts that all these assets are owned by the company. They do not belong to
anyone else. This is the rights and obligations assertion. The five assertions of clients’ financial
statements are:

 Existence and occurrence: a claim regarding existence of asset and liability, and
occurrence of recorded transactions;

 Completeness - All transactions that actually occurred and accounts that should
have been recorded in the financial statements were recorded;

 Rights and Obligations – a claim that assets are actually rights of the client and
recorded liabilities are actually owed by the entity;

 Valuation or Allocation - assets, liabilities, revenues, and expenses are

appropriately valued and allocated to the proper accounting period; and

 Presentation and Disclosure – financial statement components are properly

presented and disclosed in conformity with IFRS or applicable GAAP.

 The auditor ascertains the degree of correspondence between assertions and established
criteria. The auditor examines the evidence for the assertion presentation and discloser to
determine if the accounts are described in accordance with the applicable financial reporting
frame work, such as international accounting standards, local standards or regulations and laws.

 The goal, or objective, of the auditing is communicating the results to interested users. The
audit is conducted with the aim of expressing an informed and credible opinion in a written
report. The purpose of the independent expert opinion is to lend credibility to the financial
statement. The communication of the auditor’s opinion is called attestation, or the attest
function. In an audit this attestation is called the ‘audit report’.
In plain English

An audit is…

 A logical series of steps (planning, evidence obtaining, analysis, reporting)

 Performed without bias (objectively)

 To determine if certain representations (assertions) of management (i.e., mgmt’s f/s)

 Correspond to established standards (IFRS).

The results of the audit

 are communicated in writing (audit report)

 to people who will rely on the findings (the “users”).

1.3 Nature of Auditing

An audit is a systematic examination of books, accounts, documents and reliability of accounting

statements.

It is not only to see the arithmetical accuracy of the books of accounts but it also goes further and finds
out whether the transaction entered in the books of original entry are correct or not. An auditor has to
go behind the books.

The purpose of auditing lies in ascertaining whether the working result (financial performance) and
financial position as shown by the income statement and balance sheet for a particular period are truly
determined and presented by those responsible for their compilation.

Auditing does not mean the preparation of accounts. It is the verification of accounts by an
independent person who examine and checks them and makes best use of the information supplied to
him.

An auditor is required to direct his efforts towards proving and establishing the authenticity of the
transaction by vouching all the information supplied.

Auditing, thus primarily involves

  Testing the reliability, competency and adequacy of evidence in support of monetary
transaction of an organization. Reliability of Audit Evidence:

 External evidence is usually more reliable than internal evidence.

 Internal evidence will be more reliable, when related internal controls are satisfactory

 Evidence obtained by the auditor himself is more reliable than evidence obtained from
entity.

 Documentary evidences are more reliable than oral representations.

 It is the process of testing (the reliability) and weighing (competence and adequacy) of
evidence.

 Auditing is analytic, critical and investigative.

 It has its principle roots not in accounting which it reviews but in logic on which it leans heavily
for ideas and methods.

 The function of reporting is the end-product of auditing.

 A well laid out and implemented audit program helps an auditor to arrive at proper conclusion
regarding the accounting statements and thus helps him to formulate his opinion.

1.4 Demand for Audit

The essence of demand for audit refers to the question “why do organizations request an audit?” the
answer to this question can be described as follows:

(i) Control mechanism: audit is important as control mechanisms to ensure accountability. The
auditors’ role is determining whether the reports prepared by management are in
conformity with the responsibility and duties provided in the organization policies. The
overall need for monitoring activities, need demands (requests) auditing to provide credible
or Audited financial information, Audited performance reports, Audited implementation of
rules, & regulations.

(ii) To resolve conflict of interest between management and the owners: The Agency relation
ship that exists between the owner and manager produces a natural conflict of interest.
Because, the manager has more information about the “True financial position and results
of operations of the entity than the owner who is absentee. It both parties seek to
maximize their own self interest, it is likely that the manager will not act in the best interest
of the owner. Example The manager may spend organizational funds to provide excessive
personal benefits or manipulate the reported earnings in order to earn a larger bonus.
Thus, the need for Independent (non-pertain) opinions or view is necessary to resolve such
conflicts.
 (iii) To reduce damaging Consequences: Even though, the function of accounting is to provide
information for economic decision making; this information must be verified by auditors,
before they are used for decisions that have serious and subsequent factual economic
consequences.

(iv) To simplify complexity: In our age, financial information and translation has become complex
in preparation, content, and format. Therefore it demands drippy specialized body of
knowledge to prepare (compilation), verify and interpret them.

(v) Regulatory requirements: many business laws, memorandum of association and government
regulation, make requirements’ for annual audits. For Example –For renewal of license, or
permit, (commercial code of Ethiopia), proclamation of tax requires audited financial
statements.

1.5 Rationale for an Audit

1. The objective of an audit of financial statements is to enable the auditor to express an opinion
whether, apart from representing a true and fair view of an entity’s finances; the financial statements
are prepared, in all material respects, in accordance with the applicable financial reporting framework.

2. The underlying objective is to add credibility and enhance the degree of confidence of Users of
management’s financial statements. Access to capital markets, mergers, acquisitions, and investments in
an entity depend not only on the information that management provides in financial statements, but
also on the assurance that the financial statements are free of material misstatements. This assurance is
provided, to a considerable extent, by an audit. While an audit does not guarantee financial statements’
accuracy, it provides users with a reasonable assurance that an entity’s financial statements give a true
and fair view in conformity with the applicable financial reporting framework.

The need for an audit therefore originates from the following factors:

• Requirement of Unbiased and relevant financial information to guide investment decisions of

stakeholders

• Complexity of Financial information

• Remoteness of the users from the financial information generating system and processes

• Financial and Economic consequences of using unreliable information

1.6 Accounting and Auditing

Many financial statement users and members of the general public confuse auditing with accounting.
The confusion results because most Auditing is usually concerned with accounting information and
many auditors have considerable expertise in accounting maters.
  The function of accounting is to provide certain types of quantitative information that
management and others can use to make decisions.

 In auditing accounting data, the concern is with determining whether the recorded
information properly reflects the economic events that occurred during the accounting
period.

Accounting is the recording, classifying, summarizing and reporting of economic events for the purpose
of providing financial information used in decision making.

Auditing is determining whether recorded information properly reflects the economic events that
occurred during the accounting period

1.7 Types of Audits and Auditors

i. Types of Audits

Using different parameters we can classify audits in to different types. Such parameters include
organizational structure, time, scope, and objective.

Accordingly, audits are often viewed as falling in to three major categories:

1. Financial statement audit

2. Compliance audit

3. Operational audits

1) financial statement audit

 Audit of financial statements covers the balance and related statements of income,
retained earning, and cash flows.

 The goal is to determine whether these statements have been prepared in accordance
with GAAP.

 This audit normally performed by CPA (Certified Public Accountants)

 Users of Audit reports include management, investors, bankers, creditors, financial

analysts and government agencies.

2) compliance audit

 Is carried out to determine if entities are complying with applicable laws, regulations,
policies and regulations

 It is performed by GAO (General Accounting Officer) or compliance officers

  The audit is an appraisal activity which measures the extent to which organizational
objectives are meat.

3) Operational Audit

 An operational audit is a study of a specific unit of organization for the purpose of

measuring its performance.

 Operational audit is concerned with the operating efficiency and effectiveness of

functional areas of an organization. It takes into consideration

 Inefficient operations both from the time and cost angles;

 Wastage of resources through lack of propriety in expense; and

 Effectiveness in achieving goals, objectives and plan set for the functional area.

 It is aimed at improving the profitability of the organization and simultaneously at

achieving the other organizational goals.

 It is difficult to identify established criterion for operational audits the only criterion to
be used is good business common sense, best practices etc.

 Operational audits are much less structured and more customized for each individual
audit than financial audits.

ii. Types of auditors

There are three basic types of auditors these are:

1 Internal auditor

2 External auditors (independent auditors) and

3 Government auditors

1) Internal auditor

Internal auditors are employed by the organizations they audit. These auditors may review

 Employee performance;

 Compliance with company regulations; and

 Financial and accounting systems.

Internal auditors allow company leaders to be informed of what is happening within the company and
to address issues or concerns early. Internal auditors have the following features:

 They are full-time employees of private or public organizations who are hired to conduct audits
of those organizations.

 They often report to the audit committee of the board of directors and also to the president or
another high executive.

 Internal auditors perform both compliance and operational audits for there companies.

2) External Auditors (independent auditors)

 They are independent of the organizations whose representations are being audited

 They offer their audit services on a contractual bases

 The independent auditor is paid a fee by the auditee, and is responsible primarily to third parties

 The majority of audits performed by external auditors are financial statement audits.

3) Government auditors

 They are auditors representing local, state and federal Government entities

 Government auditors perform financial statement audit, compliance audit and operational
audit.

\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\\
 CHAPTER TWO
THE AUDITING PROFESSIONAND LEGAL LIABILITY

Introduction

The work of an independent auditor is to express an objective opinion on financial statements of an

organization. To have this objectivity an auditor needs to have an independent physical and mental
attitude at all time in his work. This is one of the major ethical issues that auditors have to deal with and
need guidance on.

This chapter looks at the principles and guidelines that auditors frequently refer to when conducting
their audit work. Auditors can be charged or sued because of their work. This unit also looks at why
auditors can be charged and how they can avoid legal liability. In addition, the auditing professional view
on many aspects of the audit will be discussed.

2.1. GENERALLY ACCEPTED AUDITING STANDARDS (GAAS)

Generally Accepted Auditing Standards

Auditing standards are measures of the quality of the auditor's performance.

The American Institute of Certified Public Accountants (AICPA) first issued the ten generally accepted
auditing standards (GAAS) in 1947 and has periodically modified them to meet changes in the auditor's
environment.

The GAAS are composed of three categories of standards:

 General standards of qualification and conduct;

 Standards of fieldwork; and

 Standards of reporting.

Auditing standards must be viewed and interpreted in at least two deferent ways.

 First auditing standards need to be viewed as the minimum level of performance standards
required to be observed by auditors in performing their duties. The auditor must understand
and recognize that most professional auditing standards are broad and seldom specifically
address the actual problems that arise in individual audit engagement.

 Second professional auditing responsibilities are achieved if the independent auditor performs
an audit in accordance with GAAS. Therefore, the auditor meets professional auditing
responsibilities in the context of existing professional auditing standards that requires the
constant exercise of professional judgment.
Thus, many auditing experts believe that professional auditing standards should be viewed in the latter
context because there is simply no way to establish standards in such detail that professional judgment
is minimized or eliminated. Since professional auditing standards seldom provide the exact answer, they
should be viewed as minimum guidelines that set the tone for the auditing profession.

General Standards of Qualification and Conduct

1) The audit is to be performed by a person or persons having adequate technical training and
proficiency as an auditor.

2) An auditor must maintain an independent physical and mental attitude.

3) An auditor must exercise due professional care in his work.

Standard of Fieldwork:

1) Auditor's work must be properly planned and supervised.

2) Auditor's must study and evaluate internal control.

3) Auditor must gather sufficient and competent evidence.

Standards of Reporting:

1) The audit report must state whether financial statements have been prepared in accordance
with Generally Accepted Accounting Principles (GAAP).

2) The audit report must state whether the GAAP has been consistently applied with that of the
preceding period.

3) The audit is to be presumed to have adequate information disclosure unless and otherwise
stated so.

4) The audit report must maintain an expression of opinion on the financial statements as a
whole or an explanation for not expressing an opinion.

2.1.1 General Standards of Qualification and Conduct

The three general standards are concerned with the auditor's qualification and the quality of his or her
work.

2.1.1.1 Technical training and proficiency of an auditor

The first general standard recognizes that an individual must have adequate training and proficiency as
an auditor.

 This is gained through formal education, continuing education programs, and experience.
  It should be recognized that this training is on going with a requirement on the part of the
auditor to stay up to date with current accounting and auditing pronouncements.

 Auditors should also be aware of developments in the business world that may affect the
auditing profession.

2.1.1.2 Auditors independence in physical and mental attitude

The second general standard requires that the auditor always maintain an attitude of independence on
an engagement.

 This standard is related with assurance service of the profession and hence it is unique to the
auditing profession;

 The need for independence is a result of the auditor’s responsibility to users of the financial
statements;

 Independence precludes relationships that may impair the auditor's objectivity;

 A distinction is often made between independence in fact and independence in appearance. An

auditor must not only be independent in fact but also avoid actions that may appear to affect
independence in appearance.

 If an auditor is perceived as not being independent, users may lose confidence in the auditor's
ability to report truthfully on financial statements.

 Lack of independence by auditors put the integrity and fairness of the financial statements in to
question;

 Public confidence is impaired if an auditor is found to lack independence.

2.1.1.3 Due professional care in his work

Due professional care is the focus of the third general standard.

 In simple terms, due professional care is that the auditor performs his or her duties with a
degree of skill commonly possessed by others in the profession.

 The third general standard imposes an obligation on the members of the audit team to observe
the standards of field work and reporting, and to perform the work at the same level as any
other professional auditor who offers such services to clients could do.

2.1.2 Standards of Field Work

The standards of fieldwork relate to the actual conduct of the audit.

There are three standards under this category. They provide the conceptual background for the audit
process.

2.1.2.1 Planning and supervision

 The first standard of fieldwork deals with planning and supervision. This standard gives
recognition that successful completion of an audit engagement requires proper planning.

 Adequate planning of an audit encompasses features such as client orientation, determination

of man power requirements and efficient utilization of a firm’s resources;

 Proper planning can lead to a more effective audit that is more likely to detect material
misstatements if they exist;

 Proper planning also assists in completing the engagement in a reasonable amount of time.

 Additionally, the standard requires that assistants on the engagement be properly supervised.
When two or more auditors are involved in engagement, there must be system of review and
supervision

 The degree of supervision will deepened upon a variety of factors such as the background of the
assistant and the nature of the work being performed by the assistant

2.1.2.2 Study and evaluate internal control

 The second standard of fieldwork requires that the auditor gain sufficient understanding of the
auditee's internal control to plan an audit.

 The internal control over financial reporting provided in the accounting policies and procedures
of an organization should be in a manner that enables the entity to process, record, summarize,
and report financial data consistent with assertion reflected in its financial statements.

 The auditor’s responsibility is to understand a client’s internal control structure to a degree that
allows the auditor to determine the nature ,extent, and timing of audit procedures in a manner
that assure the audit will be both effective and efficient.

Internal control is a process, effected by an entity's board of directors, management and other
personnel that is designed to provide reasonable assurance regarding the achievement of the following
objectives:

 Reliability of financial reporting. Financial Reporting” relates to preparation of reliable

published financial statements. This includes periodical reporting and annual report. Examples
of internal control over financial reporting includes segregation of duties, authorization limit,
dual signatory, physical count of stocks and cash, periodic reconciliation of balances,
documentation of transaction supporting files
  Compliance with applicable laws and regulations. Compliance” relates to the entity’s
compliance with applicable laws and regulations. This may include: Securities and Exchange
Commission (SEC), Federal Deposit Insurance Corp. (FDIC), Environmental Protection Agency
(EPA), Internal Revenue Service (IRS). Effectiveness of Internal Controls over Compliance can be
judged effective if: The Board of Directors and management have reasonable assurance that
applicable laws and regulations are being complied with),and

 Effectiveness and efficiency of operations. This is related to the effective and efficient use of
the entity’s resources such as fixed assets, people, money, reputation, production capabilities.
Thus, effectiveness of Internal Controls over Operations can be judged effective if: The Board of
Directors and management has reasonable assurance that they understand the extent to
which the entity’s operations are being achieved.

The degree to which the auditor relies on the auditee's internal control directly affects the nature,
timing, and extent of the work performed by the independent auditor.

2.1.2.3 Sufficient and competent evidence

 Sufficient, competent evidence is the focus of the third fieldwork standard.

 Sufficient competent evidential matter is to be obtained through inspection, observation,

inquiries and confirmation to afford reasonable bases for an opinion regarding the financial
statements under examination.

 The standard requires that the auditor collect sufficient and competent evidential matter as a
base for drawing a conclusion about the reliability of a client’s financial statement.

 The sufficiency of evidential matter relates to the quantity of evidence acquired through
confirmation, observation, inquire, and the use of other audit techniques.

 Competent evidential matter refers to the quality of the evidence gathered. Ultimately, what
constitutes sufficient and competent evidence is a matter of professional judgment.

2.1.3 Standards of Reporting

The four standards of reporting are presented below:

5) The report shall state whether the financial statements are presented in accordance with
general accounting principles.

6) The report shall identify those circumstances in which such principles have not been consistently
observed in the current period in relation to the preceding period.

7) Informative disclosers in the financial statements are to be regarded as reasonably adequate

unless otherwise stated in the report.
 8) The report shall either contain an expression of opinion regarding the financial statements,
taken as a whole, or an assertion to the effective that an opinion cannot be expressed.

Generally Accepted Accounting Principles: In preparing his/her report, the auditor should state whether
the financial statements are in accordance with generally accepted accounting principles or not.
Generally accepted accounting principles, as used in the standard of reporting, indicate the application
of such principles in the preparation of financial statements. But you have to note that the auditor
should not state the financial statements are in accordance with GAAP if they are not actually so.

Consistency: the auditor should demonstrate in his/her report a consistent application of GAAP in the
preparation of financial statements. Consistency as it is applies to standards of reporting requires the
auditor to state in his/her report if there is a change in the accounting principles that materially affect
the comparability of the financial statements.

Informative Discloser: the auditor has to evaluate whether all information that will have material effect
on the statements is disclosed.

Expressing opinion: the auditor‘s opinion indicates whether the financial statements are fairly
presented or not. It is for this reason that the standard of reporting requires the auditor to express
his/her opinion on the financial statements based on his/her findings. If the auditor is unable to from
opinion due to various reasons, she/he has to state the reasons clearly. In all cases where an auditor‘s
name is associated with the financial statements, the report should contain a clear-cut indication of the
character of the auditor‘s examination, if any, and the degree of responsibility he/she is taking.

2.2 Independence

The development of auditing as a profession is tied to the importance of independence in audit.

Independence is the corner stone to professional audit which is the reason for naming professional
auditing as independent audit.

What do we mean by independence and objectivity?

 Independence is freedom from situations and relationships which make it probable that a
reasonable and informed third party would conclude that objectivity either is impaired or could
be impaired.

 Independence is related to and underpins objectivity. However, whereas objectivity is a personal

behavioral characteristic concerning the auditor’s state of mind, independence relates to the
circumstances surrounding the audit, including the financial, employment, business and
personal relationships between the auditor and the audited entity and its connected parties.

 Thus, objectivity is a personal behavioral characteristic concerning the auditor’s state of mind or
situation that influences auditor’s formation of opinion or conclusions.
  Auditors are expected to form their opinion and conclusion based on facts and evidences they
obtained and tested in the audit process.

Other definitions of independence and objectivity have been provided as follows:

 Independence is the ability to resist client pressure;

 Independence is a function of character with characteristics of integrity and trustworthiness

being essential;

 AICPA, 1997defines independence as an absence of interests that create an unacceptable risk of

bias;

 IIA defines objectivity as a free mental attitude which auditors should maintain in performing
audit engagements. Auditors are not to subordinate their judgment on audit matters to that of
others; and

 AICPA requires auditor in their performance of audit to maintain their objectivity and integrity.
Defines objectivity as a state of mind or conditions in which auditors are free of conflict of
interest and they do not knowingly misrepresent facts or subordinate their judgment to others.

Why Do Auditors Need Independence?

The very demand for audit calls for integrity and objectivity in the person who performs the audit so
that users of the audit could put trust and confidence in the auditor and the audit work.

How can independence, integrity and objectivity be best provided or guaranteed in the auditor's
function or personality is a constant challenge of the profession. Thus, the auditing profession has tried
to delineate these within the framework of:

 Professional qualification,

 Ethics, and

 Legal liability and responsibility requisites.

2.3 Characteristics of a Profession

The most important characteristics of a profession include: a responsibility to serve the public, a
complex and specialized body of knowledge, standards of admission, and a need for public confidence.
We will discuss these characteristics as they apply to auditing.

Specialized body of knowledge

A profession has a specialized body of knowledge that member of the profession should acquire
through formal education. To practice public accounting, you have to study accountancy at a
university. Besides, the auditor needs to be knowledgeable of new pronouncements issued by the
concerned professional association. The body of knowledge is dynamic and in constant development
and growth and not static.

Standard of Qualification for Admission

A profession to be a profession must have well-recognized and accepted predetermined criteria of

qualification for admission into the profession.

The standards include educational requirement as well as other moral and legal criteria fulfillment.
The education 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 exist in the profession and
competence in it.

Standards of conduct of behavior

A professional needs to have standards of conduct that governs the behavior and activities of the
members of the profession.

The code of professional conduct is a means by which the public measures and judges the professional
quality of the members of the audit profession. To this end auditing profession has developed a code of
professional conduct that has two parts which are principles and rules of conduct.

Need for public confidence

A profession will be successful if it gains public trust and confidence. This is an extremely important
quality expected of the independent as it leads to increased credibility. The demand for audited
financial statements is a proof confidence to the auditor.

Responsibility to serve the public

In financial statements audit, the auditor is the representative of the public in the financial reporting
process. Thus, the role of the independent auditor is to insure that financial statements are fair to all
parties and not biased to favor a certain group.

To play their role effectively, auditors must maintain a high degree of independence from their client.
This shows the auditors’ responsibility to the public in other words, the auditors’ acceptance of
responsibility for the consequences of theirs action.

This does not mean only legal responsibility which arises out of the contractual obligation, but also
moral responsibility to the profession itself. Auditor has a responsibility to assure the society with the
quality of services demanded and accept sanction for failure to do so.
To conclude, we can find these characteristics in different stages of growth and development in various
professions. Some professions more than others seem to have attempted to fulfill some elements
better. The role of professional associations in the development of these is crucial. An association is a
body of professionals and it is this body that plays important role in prescribing the professional
standards and guiding their implementation.

2.4 Professional Qualification Requirements

The professional qualification requirements for auditors or qualified public accountants (CPA) in various
countries are more or less the same. The most common elements are:

 Minimum educational background which nowadays is being pushed higher and higher
completion of required specialized body of knowledge as prescribed by the profession and
proved through the passing of qualifying examinations;

 Fulfillment of prescribed practical experience;

 Moral and ethical requirements invoked through character reference; and

 Age limit for determining legal personality and responsibility.

2.5 PROFESSIONAL ETHICS OF AUDITING

A code of ethics is a comprehensive statement of the values and principle which guide;

 The daily work of auditors,

 Professional attitude; and

 Encourage high level of performance.

The enforcement of code of ethics assures the general public and the audited entities that the
auditor‘s work is fair and impartial.

The purpose of professional ethics in the auditing profession as well as in other professions is to

 build the public confidence,

 to judge the quality of audit work, and

 provide grounding guidance‘s of conduct for practitioners..

The advantages of prescribing professional ethics are to emphasize positive activity and encourage high
level of performance while preventing mal-practices. However, there is difficulty in concretize them.
  First they can only be prescribed in general terms to avoid prescribing unacceptable behavior,
and it is difficult to enforce general ideas of behavior.

 Second it is difficult to interpret behavior without reference to specific at which point it requires
interpretation of rulings according to circumstances.

Important parts of ethics in auditing are in relation to:

 Maintenance of mental and physical independence, integrity and objectivity

 General competence and technical standards

 Responsibility to client and colleague

 Other responsibility and practices that have bearing on ethical conduct include acts discreditable
to the profession, i.e. commission, incompatible occupation, soliciting, forms of practice, etc.

As an example of a highly developed professional ethics of auditing the student should refer to the
AICPA code of professional ethics. Most important elements to note in such code of ethics are:

2.6.1 Independence, Integrity and Objectivity

An auditor’s objectivity must be beyond question if he/she is to report as an auditor and this objectivity
can only be assured:

 if the auditor is in fact independent, and

 If the auditor is seen to be independent.

The threat to independence may be reduced by the nature and extent of the precautions taken by the
practitioners to guard against loss of objectivity.

An auditor must maintain an independent mental and physical attitude. He must be free from any

 Financial and positional interests, and

 Family relation in assuming a position of an auditor

Otherwise his independence will be impaired in terms of physical and mental attitude.

Threats to Independence of an Auditor

i) Undue dependence on an audit client

Objectivity may be threatened by undue dependence on any audit client or group of connected clients.
The recurring work paid by one client or group of connected clients should not exceed 15% of the gross
practice income.
 ii) Overdue fees

The existence of significant overdue fees from an audit client or group of association clients can be a
threat to objectivity akin to that of a loan. Audit firms must therefore ensure that overdue fees, along
with fees from current work, could not be construed as a loan.

iii) Actual or threatened litigation

A firm's objectivity may be threatened or appear to be threatened when it is involved in, or even
threatened with litigation in relation to a client. Litigation of certain sorts will represent a 'breakdown of
the relationship of trust' between auditor and client. This would impair the independence of the auditor
or cause the directors of the client to become unwilling to disclose information to the auditor.

iv) Family or other personal relationships

An auditor's objectivity may be threatened as a consequence of a family or other close personal or

business relationship.

Problems arise if an officer or senior employee of an audit client is closely connected with the partner or
senior staff member responsible for the conduct of the audit. In this context, closely connected people
include adult children and their spouses, siblings and their spouses, any relative to whom regular
financial assistance is given or who is indebted to the staff members or partner.

v) Beneficial interest in shares and other investments

An auditor's objectivity may be threatened where he/she holds a beneficial interest in the shares or
other forms of investment in a company upon which the practice reports.

Staff or partners should not have share holdings in client businesses. (This includes beneficial
shareholdings held by a spouse or minor children).

vi) Loans

Objectivity may be threatened by a loan to or from an audit client.

No loans or guarantees should be undertaken unless they are with client financial institutions in the
normal course of the business.

vii) Goods and Services Hospitable

Objectivity may be threatened by acceptance of goods, services or hospitality from an audit client.
Acceptance on normal commercial terms, or with only modest benefit, is acceptable.

viii) Provision of other services to audit clients

There are occasions where objectivity may be threatened or appear to be threatened by the provision to
an audit client of services other than the audit. Care must be taken to avoid performing executive
functions or making executive decisions.

2.6.2 General and Technical Competence

An auditor must possess professional competence necessary to provide competent services that meet
clear and acceptable standards and avoid the use of his/her name in an unintended activity that is,

 Preparation of technical statements that is beyond the capacity and ability of the auditor, and

 Issuance of unaudited financial statements due to lack of competence.

Auditors should not accept or perform work, which they are not competent to undertake unless they
obtain such advice and assistance as will enable them competently to carry out the work.

2.6.3 Responsibility to Clients

The auditor’s responsibility to their client requires:

 Auditor to be responsible for maintaining confidential information forwarded to him/her by a

client as a result of his/her privileged position.

 Auditor to provide his services on contingent or conditional fee bases.

In addition auditor’s responsibility to their client includes responsibility that was developed through
common law cases that relate to 'due professional care'. Thus, auditors must employ reasonable care
in all they do, in particular:

 Auditors must use generally accepted auditing techniques when seeking to satisfy themselves
that the matters upon which they report accurately reflect the true financial state of his client's
business.

 If auditors come across any matter, which puts them upon inquiry then they have a duty to
investigate such a matter until they are able to resolve it to their own reasonable satisfaction.
Auditors should not accept any explanation unless they have first carried out such investigations
as will enable them properly to assess whether the explanation offered a reasonable one.

2.7 Legal Liability and Responsibility

 The auditor is responsible for his report;

 Auditors are not responsible for the financial statements, which are the representations of
management.

 However, the auditor can be sued for causing damage to users of his audit report if he doesn't
carry out his work properly.
  In other words, auditors face legal liability if they conduct their work negligently.

 Legal liability means the probability that an auditor would be liable to a legal (court) action for
not performing his duties well.

In order to understand this section, you have to know the meaning of the following words as they are
used in the context of auditor's legal liability.

 Breach of Contract: when the auditor/client fails to meet the terms and obligations stated in the
contract for audit.

 Ordinary Negligence: an absence of reasonable or due care in performing an audit. An auditor is

negligent when he/she fails to do what other professional accountants would have done under
similar circumstances. Eg. Failure to detect that there was an error in computing depreciation.

 Gross Negligence: an extreme deviation from professional standards of due care. Eg.
Discovering but taking no action about management theft or fraud because of carelessness.

 Fraud: wrongful actions taken with the intent of deceiving client, the one whose financial
statements are being audited.

 Third Party: the contract for the audit is signed by the auditor and the client others who have
interest are referred to as third parties Eg. Creditors, investors, potential investors etc

The following table summarized the auditor's legal liability.

The auditor can be charged by For

Client Breach of contract

Negligence (gross and ordinary negligence)

Negligence (gross and ordinary negligence)

A third party known to rely on the auditor's Fraud

report for a particular purpose
Gross negligence

Fraud
Foreseen third parties
Gross negligence

Fraud
Reasonably foreseeable third parties

For any of the above parties to be able to successfully sue the auditor, they should be able to show that:

 The auditor had a duty to do something

  He did not perform his duty

 The plaintiff (person suing the auditor) relied on the work of the auditor.

 The plaintiff suffered a loss as a result of relying on the auditor's work.

Possible Charges by a Client

a) For breach of contract

The auditor would be seud for breach of contract if he fails to complete the service agreed to in the
contract with the client. Eg. If the auditor discontinues an audit without adequate cause, or fails to
submit the audit report before or on the deadline, he may be asked to repay a part or the entire fee.

b) For ordinary or gross negligence

Auditors can be sued for negligence by their clients when they fail to show due care, i.e, a level of
carefulness usually possessed by others in the profession. For example, the client may charge the
auditor for not detecting a major fraud by one employee or for letting a confidential information leak
out.

Possible Charges by Third Parties

The auditor can be charged by third parties that the auditor is well informed of that they would rely on
his report for negligence and fraud.

For example, XYZ Co. engaged ABC auditing firm, to audit its financial statements telling him that they
need the report to obtain a loan from a bank. In this case, ABC auditing firm can be held liable for both
ordinary and gross negligence to the bank in case the bank suffers a loss as a result of relying on the
auditor's opinion.

On the other hand, third parties that the auditor doesn't know would use his report can charge the
auditor and recover any losses only for gross negligence and fraud. But, the question would be how is
ordinary negligence differs from gross negligence?

Say financial statements have been deliberately overstated by management to deceive users. The
auditor has a duty to discover this. If the auditor applies GAAS properly and simply doesn't suspect the
fraud, he can only be accused of ordinary negligence. However, if the auditor suspected that there was
fraud but did not do additional investigation to try to uncover the fraud, he can be accused of gross
negligence.

If the auditor actually discovered the fraud and did not mention this in his audit report, in this case he is
participating in the fraud himself (i.e., constructive fraud).

The Auditor's Responsibility for other Illegal Acts

The auditor has a duty to uncover and report on illegal acts committed by the client or any one as long
as they are related to the financial statements.

So the auditor can be charged for not reporting illegal acts unrelated to the financial statement only if
he/she knows about them.
 Chapter Three
Audit Planning and Program Designing
3.1 INTRODUCTION

The concept of adequate planning includes:

 Investigating a prospective client before deciding whether to accept the engagement;
 Obtaining an understanding of the clients’ business operations; and
 Developing an overall strategy to organize, coordinate, and schedule the activities of the
audit staff.
Although much planning is done before beginning the actual audit field work, the planning
process continues throughout the engagement. Whenever a problem is encountered during the
audit the auditors must plan their response to the situation.
There are three main reasons why the auditor should properly plan engagements:
 To enable the auditor to obtain sufficient competent evidence for the circumstances i.e.
obtaining sufficient and competent evidence is essential if the audit firm is to minimize legal
liability and maintain a good reputation in the business community.
 To keep audit costs reasonable i.e. keeping costs reasonable helps the firm remain
competitive and there by retain or expand its client base.
 To avoid misunderstanding with the client i.e. avoiding misunderstandings with the client is
important for good client relations and for facilitating high quality work at reasonable cost.
The client must be informed of the works or steps of activities to be carried out by the
auditors in order to avoid misunderstanding. This can be best achieved through the use of
audit plan.
3.2 PREPLAN THE AUDIT

Most pre-planning takes place early in the engagement. Pre-planning involves the following
steps:
3.2.1 Decide whether to accept or continue doing the audit for the client;
3.2.2 Identifying the client’s reasons for the audit;
3.2.3 Obtain an engagement letter; and
3.2.4 Select an appropriate staff for the engagement.
3.2.1 Client acceptance and continuance
  The first step is deciding whether to accept or continue doing the audit for client.
 Independent audit firms must use care in deciding which client is acceptable and which is
not.
 Audit firms, before accepting a new client must investigate (evaluate) the company to
determine,
 The prospective clients standing in the business community;
 Financial stability of the entity;
 Relations of the client with previous auditors; and
 Its integrity. Auditors should avoid clients who lack integrity or argue constantly
about the proper conduct of the audit and fees.
This is because management with such problem can make audit performance difficult in order to
influence the auditor or hide major evidence than they are worth. Therefore, before accepting
new client, audit firms should obtain information concerning the company (client) integrity and
other concerns from the following sources:
 By reading past period financial statements;
 By communicating the potential clients previous auditors with the permission of the
client; and
 By contacting present and former business also banks, suppliers etc
3.2.2 Identifying client’s reason for audit
The auditor should gather sufficient information and identify client’s reason for the audit in order
to meet;

 The audit objectives; and

 Its intended use.
Two factors will affect audit risk--the likely statement users and their intended use of the
statements. If the statements are to be used widely, the auditor will need to amass or collect more
information in the audit.

Throughout the engagement, the auditor may get additional information as to why the client is
having an audit and the likely use of the financial statements.

This information may affect the auditor’s assessment of acceptable audit risk.
3.2.3 Obtaining an engagement letter
If there are, no serious doubts raise about the clients integrity. The auditor will sign the contract.
The audit contract is called an engagement letter.
An engagement letter is an agreement between the audit firm and the client for conducting of
the audit and related services.

The term of agreement should be in writing to minimize misunderstanding and should include
expressed duties such as:

 The nature of the work to be performed. i.e. it should specify whether the auditor will
perform audit, compilation, review, tax return preparation plus any other services.
 It should also state any restriction to be imposed on the auditors work. This
includes restrictions like
 the dead line or period of time for completing the audit;
 assistances to be provided by the clients personal in obtaining records and
documents;
 Schedules to be prepared for the auditor; and
 Agreement on fee.
 Limitation of the auditor with respect to detection of error, irregularities and illegal
acts. The auditor will explicitly state that he/she is not responsible for the discovery of all
acts of fraud, or makes no guaranty of finding such things.
3.2.4 Select an appropriate staff for the engagement (staff the engagement)
Assigning the appropriate staff to the engagement is important to meet GAAS and to promote
audit efficiency. The 1st general standard states that
 The audit is to be performed by a person having adequate technical training
and proficiency as an auditor
Staffs must therefore, be assigned with that standard in mind. On large engagements there are
likely to be one or more partners and staffs at several experience levels doing the audit.
3.3 AUDIT PLANNING

Most auditing standards require auditors to plan their work in a way that enable them to conduct
an effective audit in an efficient and timely manner.
An Audit plan is the specific guideline to be followed when conducting an audit, it helps the
auditor obtain sufficient and appropriate evidence for the circumstances, helps keep audit costs
at a reasonable level, and helps avoid misunderstandings with the client.

It addresses the specifics of what, where, who, when and how:

 What are the audit objectives?
 Where will the audit be done? (i.e. scope)
 When will the audit(s) occur? (How long?)
 Who are the auditors?
 How will the audit be done?
Plan should be made to cover, among other things:
 Acquiring knowledge of the client’s accounting system, policies and internal control
procedures;
 Establishing the expected degree of reliance on internal control;
 Determining and programming the nature, timing and extent of the audit procedure
to be performed; and
 Coordinating the work to be performed.
3.3.1 Factors to be considered when planning an audit
Following are the most important factors to be considered when planning an audit:
 The audit objective in connection with the particular audit since this will enable the
auditor to determine the nature of audit procedures to be undertaken and the type of
audit seniors and audit assistants suitable to supervise the work and carry out various
procedures.
 The preparatory maters requiring attention. For instance,
 Maters rose during previous years’ audit;
 Changes in statutory requirements and requirements of professional bodies; and
 Changes in client’s business activities and accounting and internal control systems; etc.
These are some of the preparatory matters which have an important bearing on

 The type of audit procedure to be undertaken;

 The various locations where the audit work will have to be carried out; and
  The comparative importance of each location from the point of view of audit.
 The sequence of various audit procedures to be undertaken
 Time within which the audit has to be completed and the report submitted.
Each audit will have to be tailored to the unique characteristics of the client. Hence the extent of
planning will vary according to
 The size and complexity of the specific audit;
 The auditor’s previous experience with the client, if any; and
 The auditor’s knowledge of the clients business.
This indicates that it may not be possible to lay down any hard and fast rules concerning the
steps to be followed in planning an audit. Nevertheless the following stages of audit planning
may act as a useful guide.
3.3.2 Steps of audit planning
3.3.2.1 Obtaining knowledge of clients industry and business
An auditor must have a thorough knowledge of the client's business and industry. This need has
been accentuated by the prevalence of information processing systems, global operations,
intangible asset complexities, as well as to provide consulting or other services to the client.

Business operations and processes: The auditor must strive to understand how the business
works--how revenue is generated, how the company is financed, who the customers are, etc. A
company tour is a step toward getting some familiarity, particularly if questions can be directed
to some of the employees. Additionally, identifying transactions with related parties is a
necessary step in understanding the business.

There are three primary reasons for obtaining a good understanding of the clients industry. This
are
 First, many industries have unique accounting requirements that the auditor must
understand to evaluate whether the clients financial statements are prepared in
accordance with GAAP.
 Second, the auditor can often identify risks in the industry that may affect the auditor’s
assessment of acceptable audit risk or even whether auditing companies in the industry is
advisable. Auditors need to evaluate the client's business risk, and make an assessment of
 risk of material misstatement. (acceptable audit risk is a measure of how willing the
auditor is to accept that the financial statements may be materially misstated after
the audit is completed and an unqualified opinion has been issued)
 Finally, there are inherent risks that are typically common to all clients in certain
industries. Understanding those inherent risks aids the auditor in identifying the client’s
inherent risk. (Inherent risk is a measure of the auditor’s assessment of the likelihood
that there are material misstatements in a segment before considering the
effectiveness of internal control.)
E.g. accounts receivable collection is inherent risk in the consumer loan industry
Knowledge about clients industry can be obtained in different ways. These include discussion
with previous auditor, and by having conference with the client personal.

3.3.2.2 Obtaining information about clients legal obligation

Three closely related types of legal documents and records should be examined early in the
engagement.
a. Corporate charter and bylaws
 Corporate charter (Memorandum of Association) is a legal document grate by
the state in which a company is incorporated that recognizes a corporation as a
separate entity. Corporate charter includes:
 The exact name of the corporation
 The date of incorporation
 The kind and amounts of capital stock the corporation is authorized to
issue and
 The type of business activities the corporation is authorized to conduct.
 Bylaws (article of association) include the rules and procedures adopted by stock
holders of the corporation. They specify such things as:
 The fiscal year of the corporation
 The frequency of stock holders meetings
 The method of voting for directors and the duties and powers of the
corporate officers.
b. Minutes of board of directors
  The corporate minutes are the official records of the meetings of board of
directors and stock holders.
 Corporate minutes taken at board meetings or stockholders' meetings should be
reviewed by the auditor, to determine if actions required of management have
been executed.
 They include summaries of the most important topics discussed at these meetings
and the decision made by the directors and stock holders.
 The auditor should read the minutes to obtain information that is relevant to
performing the audit.
 There are two categories of relevant information in minutes: authorizations and
discussions by the board of directors.
c. Other legal documents or contracts
 Clients become involved in different types of contracts that are of interest to the auditor.
These can include such diver’s items as:
 Long term notes and bond payables
 Stock options
 Pension planes
 Contracts with vendors for future delivery of supplies
 Royalty agreements and
 Leases
 The auditor should review and abstract the documents early in the engagement to gain a
better perspective of the organization and to become familiar with potential problem
areas.
 Various contracts, debts, pension plans, leases, and other legal documents should be
reviewed with the purpose of evaluating the client's legal compliance
3.3.2.3 Performing preliminary analytical procedure
Analytical procedure is use of comparison and use of relationships to determine whether account
balances or other data appear reasonable. For example, the auditor might compare current year
recorded commissions expense to total recorded sales multiplied by the average commission rate
as a test of overall reasonableness of recorded commissions.
Analytical procedures can be defined as "evaluations of financial information which is made by a
study of plausible relationships among financial and nonfinancial data involving comparisons of
recorded amounts to expectations developed by the auditor. In other words, do the ratios and
balances calculated appear to be reasonable?
 This step involves comparison of the client's ratios to industry standard ratios, both to see
how the client’s condition is compared to its industry, as well as to determine if the
client's ratios have changed from previous years.
 Note that the ratios include several categories--short term debt-paying ability, liquidity
activity ratios, ability to meet long term obligations, and profitability ratios.

3.4 DESIGNING AUDIT PROGRAMS

An audit program is a detailed written set of audit procedures that the auditor believes is
necessary to accomplish the objectives of the audit.

It is a set of instructions to the audit team that sets out the audit procedures the auditors should
follow and may include references to other matters such as the audit objectives, timing, sample
size, and basis of selection for each area.

It also serves as a means to control and record the proper execution of the work.

It is an important tool for the communication of audit directions to audit staff;

 It is advisable to include in the program the audit objectives for each area;
 The program should be designed so that it is in compliance with GAAS;
 It should also be in such a way that the procedures contained therein are in accordance
with the requirements and circumstances of a particular engagement; and
 The timing of audit procedures is as important as the procedure themselves.
At this stage, the procedures included in the program should enable the auditor to:

 Understand the manner in which the accounting system and related internal
controls operate;
 Determine whether they are in fact operating as understood by the audit;
 Evaluate them;
  Point out any weakness in them to the client; and
 Determine the nature timing and extent of other audit procedures to be carried out.
 A planed audit program generally serves as a guide for carrying out an organized audit
procedure.
 At the same time audit program should not be rigid: rather it should be flexible to suit
developing circumstances as the audit progresses.
Advantages of audit programs:
 It provides a clear set of instruction for the audit staff concerning the work to be
done. This would be a particular value to less experienced staff.
 It acts as a means to control the proper execution of audit work.
 It promotes that division of work among the audit staff in an organized manner.
 It emphasizes the essential procedures for audit.
 Duplication of work is avoided
 Omission of important work is avoided
 It serves as a guide in succeeding years
 Evidence of work done is available in the event of any subsequent action against
the auditor.
 It assures adherence to auditing standard and the application of GAAP.
 Preparation of an audit program forces the audit staff to consider the reasons for
performing various procedures.

CHAPTER FOUR
INTERNAL CONTROL
4.1 THE MEANING OF INTERNAL CONTROL

In discussing about modern day internal control concepts, the best reference is the model and
framework developed by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO).
COSO was formed in 1985 to sponsor the National Commission on Fraudulent Financial
Reporting (the Treadway Commission). The Treadway Commission was originally jointly
sponsored and funded by five main professional accounting associations and institutes
headquartered in the United States. These are: Institute of Management Accountants (IMA), The
American Accounting Association (AAA), The American Institute of Certified Public
Accountants (AICPA), The Institute of Internal Auditors (IIA), and Financial Executives
International (FEI).
The Treadway Commission recommended that the organizations sponsoring the Commission
work together to develop integrated guidance on internal control. Hence, these five organizations
formed what is now called the Committee of Sponsoring Organizations of the Treadway
Commission
Latter in 1992 COSO released the four volume report entitled Internal Control— Integrated
Framework. This report presented a common definition of internal control and provided a
framework against which internal control systems may be assessed and improved.
As defined by framework, internal control is a process effected by an entity’s board of directors,
management, and other personnel that is designed to provide reasonable assurance regarding
the achievement of the following objectives;
 Effectiveness and efficiency of operations,
 Reliability of financial reporting, and
 Compliance with applicable laws and regulations
Key concepts of the COSO framework
The COSO framework involves several key concepts:
 Internal control is a process. It is a means to an end, not an end in itself.
 Internal control is affected by people. It's not merely policy, manuals, and forms, but
people at every level of an organization.
 Internal control can be expected to provide only reasonable assurance, not absolute
assurance, to an entity's management and board.
 Internal control is geared to the achievement of objectives in one or more separate but
overlapping categories.
An alternative definition provided by AICPA (American Institutes of Certified Public
Accountants) defines internal control as encompassing all coordinated methods and measures
within an organization or within a system adopted and implemented to;
 Safeguard assets,
 Cheek accuracy and reliability of accounting data,
 Promote operational efficiency; and
 Encourage adherence to prescribed managerial policy.
Overall internal controls are also defined as operational checks and balances that prevent
financial loss to an organization due to fraud, waste, abuse, and mismanagement of resources.
The resources include: personnel, information and capital.
There are two kinds of internal controls:
1. Administrative controls: Administrative control is one the four management functions of
planning, organizing and leading. It is a set of procedure necessary for monitoring and
evaluation of implementation of plan. It is an integral part of an organization's internal
control system.
2. Accounting controls: Accounting controls emphasize on reliability of financial records and
safe grading of assets and records for providing reportable assurance on transaction &
financial information needed for appropriate action.
4.2 PURPOSES AND OBJECTIVES OF INTERNAL CONTROL

The purpose of internal control can be explained into two aspects:

 The management (client) concern; and
 The Auditors concern.
4.2.1 The client concern – the reason an organization establishes a system of internal control
is to attain objectives (goals). Generally management has six purposes in setting good
system of internal control. These are to:
 Achieve reliability of accounting records;
 safeguard assets;
 increase profitability;
 prevent and defeat frauds and errors;
 prepare financial statements timely; and
  Comply with laws, rules and regulations.
4.2.2 Auditors concern: The generally accepted auditing standard for field work, standard
number two requires auditors to gain sufficient understanding of clients internal control
system in order to plan the audit and determine the nature, timing and extent of testes to
be performed.
Thus, the primary purpose of studying and evaluating of internal control system by
external auditors is to determine the amount of audit work.
It is assumed that good internal control provides more reliable financial data and
statements.
4.3 COMPONENTS OF INTERNAL CONTROL

The internal control of all organizations includes five components as provided in COSO
framework:
 The control environment;
 Risk assessment;
 Control activities;
 Information and Communication; and
 Monitoring.
4.3.1 THE CONTROL ENVIRONMENT
4.3.1.1 Definition of Control Environment
Control Environment is the attitude, awareness, and actions of the board, management and
owners about the importance of control.
 It refers to the overall tone of the organization which influence the control consciousness
of its people
 This includes integrity and ethical rules, commitment to competence, board or audit
committee participation, organizational structure, assignment of authority and
responsibility, and human resource policies and practices.
 Control Environment refers to the actions, policies, values, and management styles that
influence, and set the tone of, a firm's day-to-day activities.
If “tone at the top” is weak and ineffective, then any monitoring effort is destined for failure.
Every aspect and component of internal control is dependent on the attitude and beliefs
communicated and conveyed by the management team and the board. If there is a negative
attitude toward monitoring, this will be reflected in the attitudes of employees and how they
perform the monitoring process. Management and the board set the tone at the top and it is
important for them to walk the walk and not just talk the talk.
4.3.1.2 Factors of Control Environment
Control environment is the foundation for the other components of internal control and the
control environment factors include;
 Integrity and ethical values;
 Commitment to competences;
 Broad of directors or audit committee participation;
 Management‘s philosophy and operating style;
 Organization structure;
 Human resources policy and practices; and
 Assignment of authority and responsibility.
a) Integrity and ethical values
Many companies have high values and seek to promote honesty and integrity among their
employees on a day-to-day basis.

 Clearly, if it is evident that such values do exist and are communicated effectively to
employees and enforced, this will have the effect of increasing confidence;
 In the design;
 In the administration; and
 In the monitoring of controls – leading to a reduced risk of material
misstatement in a company’s financial statements.
 Management should establish behavioral and ethical standards that discourage employees
from engaging in acts that would be considered dishonest, unethical, or illegal.
 To be effective, these standards must be effectively communicated by appropriate means
including official policies, codes of conducts, and by example.
 For example the existence in a company of comprehensive and ethical procedures or
comprehensive anti-bribery and corruption policies and procedures with regard to the
granting of credit facilities to customers and the pursuance of payment for goods and
 services supplied, together with regular supervisory control in this respect, is likely to lead
to increased audit confidence in the trade receivables area.
 Another way to reduce the incidence of improper behavior is to remove or reduce the
temptations and incentives to engage in such behavior. For example, fraudulent financial
reporting has often resulted from situations in which individuals were placed under pressure
to meet unrealistic performance goals.
b) Commitment to competence
 Competence is the knowledge and skills necessary to accomplish tasks that define the
individual’s job.
 It is self-evident that if individual employees are tasked with carrying out duties that are
beyond their competence levels, then desired objectives are unlikely to be met. For example,
there is an increased probability that the objective of avoiding material misstatement in a
set of complex financial statements will not be met if prepared by an inexperienced
company accountant.
 Thus, where management have taken measures to ensure employees who participate in
internal control are competent to carry out relevant tasks effectively, it follows that the
auditor will have increased confidence in internal control relevant to the audit,.
 Measures taken by management in this regard can cover a range of activity including for
example, rigorous technical and aptitude testing at the employee recruitment stage and in-
house or external training courses and mentoring from more senior colleagues.

c) Participation by board of directors or audit committee

 The board of directors of a share company are charged with the company’s governance.
 They are responsible for overseeing the strategic direction of the company and its
obligations related to its accountability – for example, to governments, shareholders and to
society in general.
 The control environment of an organization is significantly influenced by the effectiveness
of its board of directors or the audit committee.
 Factors that bear on the effectiveness of the board or audit committee include
 The extent of its independence from management;
 The experience and stature of its members;
 The extent to which it raises and pursues difficult issues with management (challenging or
questioning the managements’ actions or decisions); and
 Its interaction with the internal and external auditors.
 The audit committee of the board of directors should be composed of qualified outsiders
who are neither officers nor employees of the organization.
 This enables the audit committee to be;
 Effective to overseeing the quality of the organization‘s financial reports; and
 Acting as a deterrent to management override of internal controls and to management fraud.
d) Organizational structure
 Another control environment factor is entity‘s organizational structure.
 A well-designed organizational structure provides a basis for planning, directing, and
controlling operation.
 Organizational structure divides authority, responsibilities, and duties among members of an
organization
 In doing so it deals with such issues as centralized versus decentralized decision making
and appropriate segregation of duties among the various departments.
 When management decision making is centralized and dominated by individuals, that
individual‘s moral character is extremely important to the auditors.
 When a decentralized style is used, procedures to monitor the decision making of the
many managers involved become equally important.
 To ensure proper segregation of duties, the organizational structure of an entity should
separate responsibilities for
 Authorization of transactions;
 Record keeping for transaction; and
 Custody of assets.
 In addition to these to the extent possible, the execution of the transaction should be
segregated from these other responsibilities.
e) Human resource policies and procedures
 Ultimately, the effectiveness of an internal control structure is affected by the
characteristics of the organization‘s personnel.
  Thus, management‘s policies and practices for hiring, training evaluating, promoting,
and compensating employees have a significant effect on the effectiveness of the control
environment.
 Effective human resources polices often can mitigate other weakness in the control
environment but they do not guarantee against losses from dishonest employees.
f) Assignment of authority and responsibility
 The larger a company’s scale of operations, then the larger the size of the workforce and,
inevitably, the larger the amount of assignment of authority and responsibility that is
required. Assignment of responsibility and authority is directly linked to size of operation.
 Assignment of authority and responsibility need ensure that appropriate levels of
assignments are made to appropriately qualified and experienced individuals. Besides, it is
also required to ensure that adequate reporting relationships and authorization hierarchies
are in place.
 Additionally, individuals need to be properly resourced and made fully aware of their
responsibilities and of how their actions interrelate with the actions of others and
contribute to the objectives of the company.
 If a company is not successful in meeting each of these needs, then there is an increased
probability of ineffective decisions, errors and oversights by employees leading to an
increased risk of material misstatement in its financial statements. For example, where a
wages clerk is authorized to process the wages payroll and is then assigned the
(inappropriate!) authority to enter new employee details into the wages master file.
g) Management philosophy and operating styles
 A company’s board of directors or management will comprise of individuals each with a
different mindset as to philosophy and operating style, manifested in characteristics such as their:
 Approach to taking and managing business risk
 Attitudes and actions toward financial reporting
 Attitudes toward information processing and accounting and functions personnel.

Each of the above characteristics underlies a company’s control environment and it is crucial for
an auditor to have an understanding of them. Dealing with each in turn:
 (i) Approach to taking and managing business risk.
 Business risk is the risk inherent in a company’s business and arises as a consequence of the
company’s day-to-day operations and it comprises several components such as financial risk,
operational risk, compliance risk.
 The directors’ or managements’ approach to taking and managing business risk has obvious
ramifications on a company’s financial statements and the auditor should be aware of the
various factors that influence directors in this area, and of applicable controls in place.
 It is often the case that a newly established company with young entrepreneurial directors and a
flat management structure will have a more liberal approach to taking and managing business
risk than a well-established company with more experienced directors, and a steep hierarchical
management structure.
 Consequently, it is likely that there would be a lower level of a risk of material misstatement in
the financial statements of the latter company.
(ii) Attitude and actions toward financial reporting
 Financial Reporting Standards exist to help facilitate fairness, consistency and transparency of
financial reporting.
 However, some determinants of profitability such as the measure of depreciation, the
valuation of inventory or the amount of a provision remain open to the subjective judgment of
management.
 Consequently, the auditor needs to gain an understanding of directors’ attitudes and actions to
financial reporting issues and then make a judgment as to the extent of reliance that can be
placed upon these.
 It may be that a company that is struggling in a faltering economy, and in another driven by a
culture to report increasing profits, there is a tendency to adopt aggressive (as opposed to
conservative) accounting principles, in order to meet profit expectations.
 Clearly, on such audit engagements it is important for the auditor to remain resolute in exercising
appropriate levels of professional skepticism throughout.
(iii) Attitude towards information processing and accounting functions and
personnel
 The financial reporting (accounting) and information processing functions of a company are
vital to a company’s ongoing existence. Thus they need to be properly financed and resourced
 with sufficient numbers of appropriately qualified staff and contemporary information and
communications technology.
 In most large companies directors recognize that business risk will be significantly reduced, if
the company has effective information processing and accounting functions and there is an
ongoing program of investment in these.
 However, this situation does not apply to all companies. In some, both functions may be seen by
the directors merely as necessary functional overhead areas of the business and, as such, they
become under-funded and inadequately resourced.
 An auditor engaged on an audit in such a company should be aware that there is an increased risk
of material misstatement in the financial statements.
4.3.2 RISK ASSESSMENT
The second component of internal control is risk assessment.

 Management should clearly consider the factors that affect the risk that the organizations
objectives will not be achieved.
 When considering the financial reporting objective, these risks include threats to preparing
financial statements in accordance with generally accepted accounting principles. For example,
the following factors might be indicated of increased financial reporting risks:
 Changes in the organization regulatory or operating environment;
 Changes in personnel;
 Implementation of new modified information system
 Rapid growth of the organization
 Change in the technology affecting production process or information‘s system.
 Introduction of new lines of business, production process or information system
 Management‘s process of risk assessment is similar to the auditor‘s assessment of audit risk.
 However, the scope of management s risk assessment in more comprehensive in that it involves
considerations of factors that affect all of the organization‘s objectives.
 The auditors are concerned only with the levels of inherent risk and control risk that affect the
organization‘s ability to produce financial statements that are in accordance with generally
accepted accounting principles.
4.3.3 CONTROL ACTIVITIES
 Control activities are the policies and procedures that help ensure that actions identified as
necessary to manage risks are carried out properly and in a timely manner.

Control activities include reviews of performance, approvals, authorizations, verifications,

reconciliations, security of assets, segregation of duties, and controls over information systems
(general and application controls).

1. Reviews of Performance: – Management compares information about current performance to

budges, forecasts, prior periods, competitors, or other benchmarks to measure the extent to which
goals and objectives are being achieved and to identify unexpected results or unusual conditions
which require follow-up, change in strategies or other measures to be taken.
2. Controls over Information Systems: A variety of control activities is performed to check the
accuracy, completeness and authorization of transactions.
The two broad categories of information processing controls include
 General controls, which apply to all information processing activities For example general
controls include those that restrict access to the entire accounting information system. and
 Application controls, which apply only to a single application. For instance consider the control
over payroll that help to ensure that (1) only authorized payroll transactions are processed and
(2) authorized payroll transactions are processed completely and accurately. They are designed
to control application processing, helping to ensure the completeness and accuracy of transaction
processing, authorization, and validity.
3. Security of Assets – Access to equipment, inventories, securities, cash, and other assets is
restricted; assets are periodically counted and compared to amounts shown on control records.
4. Segregations of Duties – Duties are segregated among different people to reduce the risk of error
or inappropriate action. Normally, responsibilities for initiating transactions, approving
transactions, recording transactions, handling the related asset(s), reconciling balances, and
reviewing reports are separated. (One person cannot steal and conceal)
5. Approvals, Authorizations, and Verifications – Management authorizes employees to perform
certain activities and to execute certain transactions within limited parameters. In addition,
management specifies those activities or transactions which need supervisory approval before
they are performed or executed by employees. A supervisor’s approval implies that he or she has
 verified and validated that the activity or transaction conforms to established policies and
procedures.
6. Authorization – Control activities in this category are designed to provide reasonable assurance
that all transactions are within the limits set by policy or that exceptions to policy have been
granted by the appropriate officials.
7. Review and approval – Control activities in this category are designed to provide reasonable
assurance that transactions have been reviewed for accuracy and completeness by appropriate
personnel.
8. Verification – Control activities in this category include a variety of computer and manual
controls designed to provide reasonable assurance that all accounting information has been
correctly captured.
9. Reconciliations – An employee relates different sets of data to one another, identifies and
investigates differences, and takes corrective action, when necessary.
4.3.4 INFORMATION AND COMMUNICATION
Pertinent information must be identified, captured and communicated in a form and timeframe
that enable people to carry out their responsibilities.
Information systems produce reports, containing operational, financial and compliance-related
information, that make it possible to run and control the business.
 Information is necessary for any organization to carry out internal control responsibilities that support
the achievement of its objectives. Management obtains or generates and uses relevant and quality
information from both internal and external sources to support the functioning of other components of
internal control.
 Communication is the continual, iterative process of obtaining, providing, and sharing information
necessary to meet the operational, reporting, and compliance responsibilities of the organization. There
are two form of communication internal and external.
Internal communication is the means by which information is disseminated throughout the
organization, flowing up, down and across.
 An essential part of internal communications is the clear message from senior management that
control responsibilities must be taken seriously.   
 In the formal and informal communications channels that exist internally, it is vital that the
messages remain consistent as they travel across organization. 
 External communication is twofold: it enables inbound communication of relevant external
information, and it provides information to external parties in response to requirements and
expectations. 
 Incoming information (i.e. new laws, regulations, deadlines) must be routed to the right place in
time for it to be useful in execution or adjustment of planned activities. 
 Outgoing information should be reviewed for accuracy and completeness before being
dispatched (i.e. regulatory reporting).
4.3.5 MONITORING
 The monitoring part of the internal control framework is performed through application of
ongoing monitoring activities, separate evaluations or a combination of the two. These
evaluations ascertain whether other components of internal control continue to function as
designed and intended.
 Ongoing monitoring occurs in the course of operations. It includes regular management and
supervisory activities, and other actions personnel take in performing their duties.
 Even the best internal control systems should adapt to changes in the company or the business
environment. Thus, these evaluations facilitate identification of internal control deficiencies and
communicate them to appropriate officials responsible for taking corrective action.
 More serious deficiencies are communicated to higher levels of management and to the board of
directors when appropriate.
4.4 LIMITATIONS OF INTERNAL CONTROL

 An internal control system should be designed and operated to provide reasonable assurance.
That is an entity’s cost of internal control system should not exceed the benefits that are expected
to be derived.
Therefore the idea of reasonable assurance arises from two concepts:
 Cost – benefit, and
 The inherent weakness:
The cost – includes paying employees for implementing the control system, constructing and
acquiring facilities (safes, stores), printing of vouchers, forms, etc. The benefits include
prevention of potential losses.
The inherent limitations include management override of internal control, personnel errors, or
mistakes, and collusion.
 Management override of internal control: an entity’s controls may be overridden by
management. For example, member of the top management may instruct lower level employee
purchases that are not incompliance with the organization’s policy or procedure which is
violation of internal control. The lower level employee may execute the purchase even though
he/she knows that it is a violation of control, because of fear of losing his/her job.
 Personnel errors or mistakes /human error/ – The internal control system is only as effective
as the personnel who implement and perform the controls. For example, employees may
misunderstand instructions or make errors of judgment. They may make mistakes because of
personal carelessness, distraction, or fatigued.
 Collusion – the effectiveness of segregation of duties lies in the individuals performing only
their assigned tasks or in the performance of one person being checked by another. What if the
two persons assigned in duties segregated in to two agree or collide and engage in steal and
conceal.

4.5 THE AUDITORS CONSIDERATION OF INTERNAL CONTROL

The second standard of field work states that sufficient understanding of the internal control
structure is required from the auditor in order to plan the audit and to determine the nature,
timing, and extent of the tests to be performed.
The auditors’ understanding of their clients’ internal control provides a basis both to:
 Plan the audit, and
 Assess control risk
In planning an audit it is essential that the auditors have a sufficient understanding of the clients’
internal control structure. This encompasses both
 Understanding of the design of the policies, procedures, and records; and
 Knowledge of whether they have been placed in operation by the client.
It is difficult to imagine designing tests of financial statement balances without an understanding
of the internal control structure. For example, auditors who do not understand the client‘s
policies and procedures for executing and recording credit sales would have a difficult time
substantiating the balances of accounts receivable and sales.
 The auditor’s consideration of the internal control also provides a basis for their assessment of
control risks.
 Control Risk is the risk that material misstatements will not be prevented or detected by the
client‘s internal control structure.
 If the auditors determine that the clients’ internal control is effective, they will assess control risk
to be low.
 They can then accept a higher level of detection risk, and substantive testing can be decreased.
 Detection Risk is the risk that the auditors will fail to detect the misstatements with their audit
procedures. Detection risk is restricted by performing substantive tests.
 Conversely, if internal controls are weak, control risk is high and the auditors must increase the
scope of their substantive test to limit the level of detection risk.
 Therefore, the auditor’s understanding of internal control is a major factor in determining the
nature, timing, and extent of substantive testing necessary to verify the financial statements
assertion.
Since an effective internal control structure is a major factor in an audit, the question arises as to
what action the auditors should take when internal control is found to be seriously deficient.

Can the auditors completes a satisfactory audit and properly express an opinion on the fairness of
financial statements of a company in which control risk is considered to be extremely high? The
answer to this question depends on whether the auditors believe that inherent risk is at a
satisfactory level so that substantive test can be designed that will bring audit risk to an
acceptable level.

For example, the auditors of a small business with a limited segregation of duties often apply an
approach of restricting detection risk through extensive substantive tests of financial statements
assertions, rather performing tests of internal control.

4.6 OBTAINING UNUNDERSTANDING OF THE INTERNAL CONTROL STRUCTURE

In every audit the auditors must obtain understanding of the internal control structure sufficient
to plan the audit. This understanding should include knowledge of the internal control and
whether they have been placed in operation by the entity.
 The auditors understanding of the internal control structure encompasses not only the design of
the policies and procedures, but also whether they have been placed in operation.

The term placed in operation means that the policy or procedure actually exists and is in use; that
is, it does not just exist in theory or on paper.

While obtaining understanding of internal control, the auditors may also obtain evidence about
the operating effectiveness of various controls.

Operating effectiveness deals with

 How a control is applied? Is it applied as intended or as stated in the policy and procedure,
 The consistency with which it is applied, and
 Who applies the control? Does every one responsible for their implementation apply them?
The distinction between knowing that a control has been placed in operation and obtaining
evidence on its operating effectiveness is important.

To properly plan the audit, auditors are required to determine that the major controls have been
placed in operation but they may not be required to evaluate their operating effectiveness.

However, if the auditors wish to assess control risk at a level lower than the maximum, they must
have evidence of the operating effectiveness of the controls.

In planning the audit, the knowledge is used to:

1. Identify types of potential misstatements
2. Consider factors that affect the risk of material misstatement.
3. Design substantive tests
In making a judgment about the necessary understanding of the internal control structure, the
auditors consider knowledge related to the above three factors that has been obtained through
other sources, such as previous audits and their understanding of the industry in which the client
operates. They also consider their assessment of inherent judgment about materiality and the
nature of the entity‘s operations.
In any case auditors understanding of the internal control structure must encompass the control
environment, risk assessment, the accounting information and communications systems, control
activities, and monitoring.
 The control Environment: the auditors must obtain sufficient knowledge to understand
management‘s attitude, awareness, and actions concerning the control environment. It is
important that the auditors concentrate on the substance of controls, rather than their form. For
example, an organization may have a code of conduct prohibiting unethical activities, which is
not enforced by top management.

Risk Assessment: the auditors must obtain sufficient knowledge of the risk assessment process
to understand how management considers risks relevant to financial reporting objectives,
estimates their occurrence, and decides on actions to adders those risks.

The accounting Information and communication system: To understand the accounting

information system,
 The auditors must first understand the major type of transaction engaged in by the entity.
 Next, the auditors must become familiar with the treatment of those transactions. Including
how they are initiated, the related accounting records, and the manner in which the
transactions are processed.
 Finally, the auditors must understand the financial reporting process used to prepare financial
statements, including the approaches used to develop accounting estimates like depreciation and
inventory valuation. Control Activities: while obtaining an understanding of other components of the
internal control structure, auditors generally obtain some knowledge about the client‘s control activities.
 For example, while obtaining an understanding of documents relating to cash transactions, it is
likely that the auditors will discover whether the bank accounts are reconciled.
 Whether it is necessary for the auditors to devote additional attention to obtaining an
understanding of other control activities depends on the circumstances of the engagements.
 The auditors may find it necessary to understand and test certain control activities to audit a
particular assertion.
 For example, when auditing a charitable organization that receives significant cash donations, the
auditors may be unable to effectively plan the audit for the completeness assertion for cash
contribution without understanding and testing control procedures related to cash receipts.
 In other circumstances the auditors may conclude that it would be too costly to audit a particular
assertion using only substantive procedures; the most efficient course of action is to increase
their understanding and testing of the client‘s internal control policies and procedures.
 Monitoring: Finally, the auditors should obtain a sufficient understanding of the entity‘s
monitoring methods relating to financial reporting to understand how those activities are used to
initiate actions to address inadequate performance. The auditors will also consider how the work
of the internal auditors contributes to the internal control structure.

4.7 SOURCES OF INFORMATION ABOUT INTERNAL CONTROL:

How do auditors gain an understanding of the client‘s internal control structure?

 Auditors obtain information about internal control by inquiry of appropriate client personnel,
 Inspecting various entity documents and records, and
 Observing control activities and operations as they are performed.
 Auditors may ascertain the duties and responsibilities of client personnel by inspecting
organization charts and job descriptions, and interviewing client personnel.
 Many clients have procedures manuals and flowcharts describing the approved practices to be
followed in all phases of operations.
 Another excellent source of information is in the reports, working papers, and audit programs of
the client‘s internal auditing staff.

CHAPTER FIVE
AUDIT EVIDENCE

5.1 INTRODUCTION
During financial statement audit, auditors gather and evaluate evidence to form an opinion on
whether financial statements follow the appropriate criteria, usually generally accepted
accounting principles or IFRS.
Sufficient evidence must be gathered to provide an adequate basis for the auditors ‘opinion on
the financial statements.

5.2 RELATIONSHIP OF EVIDENCE TO AUDIT RISK

The term audit risk refers to the possibility that the auditors may unknowingly fail to
appropriately modify their opinion on financial statements that are materially misstated.
Audit risk is the risk that auditors may fail to detect and identify material misstatements in
financial statements and issue or express audit opinion that the financial reports are free of any
material misstatements.
Audit risk is reduced by gathering evidence-the more competent evidence gathered the less audit
risk is assumed. Obviously, one way to gather additional evidence is to increase the extent of the
audit procedures. The GAAS under the standards for field work states that:
The auditor must obtain sufficient appropriate audit evidence by performing audit procedures to
afford a reasonable basis for an opinion regarding the financial statements under audit.

5.3 FINANCIAL STATEMENTS ASSERTIONS

Audit procedures are designed to obtain evidence about the assertions of management that are
embodied in the financial statements.
When the auditors have gathered sufficient audit evidence about each material financial
statement assertion, they have gathered sufficient evidence to support their opinion. These
financial statements assertions are summarized below.
5.3.1 Existence and Occurrence
Financial statements, which generally include a balance sheet and income statement, summarize
transactions that have occurred throughout the year. The information reported on these
statements is supported by underlying accounting records, such as deposit slips and invoices. For
instance, machinery owned by a company is reported as an asset on the balance sheet and is
supported by an invoice for the purchase of the equipment. Management’s ability to select an
item on the balance sheet and present the underlying invoice to reviewers of the financial
statements affirms management’s statement that the asset exists and the purchase transaction did,
in fact, occur.
5.3.1.1 Completeness
Accountants record transactions in an organization’s general ledger, a collection of all asset,
liability, owner’s equity, revenue and expense accounts. Every transaction listed in the general
ledger is summarized in the entity’s financial statements. This assertions is that all transactions
occurred during the reporting period are completely included in the financial statements. For
instance, a customer received and paid for equipment sold by an organization. The organization’s
management deposited the funds, retained the deposit slip and recorded the transaction in the
general ledger. Management’s ability to prove that the deposited funds are reported as revenues
on the income statement supports its assertion that the financial statements are complete and
include every transaction.
5.3.1.2 Accuracy and Valuation
The accuracy and valuation assertion supports management’s statement that all items are
included in the financial statements at the correct amounts. Auditors review the accuracy and
 valuation of amounts and other data to ensure the company has recorded transactions and events
appropriately. In many instances, companies hold securities, or stock, as assets. However, the
value of securities changes on a daily basis. Management is responsible for ensuring that the
amount reported on the financial statements is accurate at the appropriate date.
5.3.1.3 Rights and Obligations
The rights and obligations assertion supports management’s statement that the company has
ownership rights to all assets and is responsible for all liabilities reported on its financial
statements. The entity must have legal control of assets and have legal obligations of liabilities to
report the amount on the financial statements. Reporting assets or liabilities that do not belong to
the organization on financial statements is misleading and distorts the overall value of the entity.
5.3.1.4 Presentation and Disclosure
Management is responsible for ensuring that the company makes no mistakes in the process of
preparing financial statements and that note disclosures are understandable and clear. Creditors
and investors use financial statements and disclosures to calculate financial ratios to compare
with similar organizations in the same industry. Auditors examine financial statements to ensure
that the amounts are reliable and are presented correctly for those who use the statements.
5.4 AUDIT RISK AT THE ASSERTION LEVEL
Since an audit involves gathering evidence for each material financial statements assertion, audit
risk can also be examined at that level. For each financial statements account, audit risk consists
of the possibility that:
 A material misstatement in an assertion about the account has occurred, and
 The auditors do not detect the misstatement.
The risk of occurrence of material misstatement may be separated into components inherent risk,
control risk and detection risk.
5.3.1.5 Inherent Risk
 Inherent risk refers to the possibility of a material misstatement of an assertion before
considering internal control. Thus, inherent risk is the susceptibility of an assertion to a
misstatement, due to error or fraud, that could be material, individually or in combination with
other misstatements, before consideration of any related controls.
 Certain characteristics of the client and its industry affect the inherent risk of a number of
financial statement accounts. For example factors such as the following are indicative of high
inherent risk for the assertions about many accounts in the client‘s financial statements.
 Inconsistent profitability relative to the industry
 Operating results that are highly sensitive to economic factors
 Going concern problems if the continuity of the organization is in question
 Large known and likely misstatements detected in prior audits
 Substantial turnover, questionable reputation, or inadequate accounting skills of
management.
 In addition, specific accounts and assertions differ in their inherent risk.
 Assume that in a given business the balance of the cash account amounts to only one-tenth
that of the buildings account. Does this relationship indicate that the auditors should spend
only one tenth as much time in the verification of cash as in the verification of the building?
The answer to this question is no. (Cash is much more susceptible to error or theft than are
buildings, and the great number of cash transactions affords an opportunity for misstatements
to be well hidden).
Assertions with high inherent risk often involve:
 Difficult to audit transactions or balances
 Complex calculations
 Difficult accounting issues
 Significant judgment, or
 Valuations that vary significantly based on economic factors.
The auditors use their knowledge of the clients industry and the nature of its operations,
including information obtained in prior year audits to assess inherent risk.

5.3.1.6 Control Risk

Control Risk is the risk that material misstatements will not be prevented or detected by the
client‘s internal control structure. It can also be defined as the probability that a misstatement
exists in the financial statements assertion due to the failure of internal control systems to detect,
prevent or correct it.
To assess control risk auditors study the methods and procedures by which the company controls
its accounting process. If these procedures are well designed and consistently followed, the
financial statements will be accurate and complete.
An effective internal control structure promotes reliability in the accounting data. Errors are
quickly and automatically brought to light by the built-in proofs and cross-checks that are in the
system.
To obtain an understanding of the client‘s internal control procedures and to determine whether
they are designed and operating effectively, the auditors use a combination of inquiry,
inspection, observation, and re-performance procedures.
If the auditors find that the prescribed practices are being consistency followed in day-to-day
operations, they will assess control risk for the related assertions to be low, and thereby accept a
higher level of detection risk.
Thus, the effectiveness of the client‘s internal control is a major factor in determining how much
evidence the auditors will gather to restrict detection risk.

5.3.1.7 Detection Risk:

The risk that the auditors will fail to detect the misstatements with their audit procedures is called
detection risk. That is, the risk that the auditors ‘procedures will lead them to conclude that
material misstatement does not exist in an account or assertion when in fact such misstatement
does exist.
Detection risk is restricted by performing substantive tests. For each account, the scope of
substantive tests, including their nature, timing, and extent, determines the level of detection risk.
5.5 MEASURING AUDIT RISK
In practice the various components of audit risk are not typically quantified. Instead, the auditors
usually use qualitative categories, such as low, medium, and high risk.
SAS 47 (AU 312), “Audit Risk and Materiality in Conducting an Audit,” allows either a
qualified or a non quantitative approach, but include the following formula to illustrate the
relationship between audit risk, inherent risk, control risk, and detection risk.
 AR=IR X CR X DR
AR= Audit Risk
IR= Inherent Risk
CR= Control Risk
DR= Detection Risk
To illustrate the measurement audit risk, assume that the auditors have assessed inherent risk for
a particular assertion at 50 percent and control risk at 40 percent. In addition, they have
performed audit procedures that they believe have a 20 percent risk of failing to detect a material
misstatement in the assertion. The audit risk for the assertion may be computed as follows:
AR=IR X CR X DR
= .50 x.40x.20 = .04
Thus, the auditors are exposed to 4 percent audit risk that material misstatement has evaded both
client‘s internal controls and the auditor‘s procedures.
It is important to realize that while auditors gather evidence to assess inherent risk and control
risk, they gather evidence to restrict detection risk at the appropriate level.
Inherent risk and control risk are a function of the client and its operating environment.
Regardless of how much evidence the auditors gather, they cannot change these risks. Therefore,
evidence gathered by the auditors is used to assess the levels of inherent and control risk.
Detection risk, on the other hand, is a function of the effectiveness of the audit procedures
performed. The more evidence that is gathered, the lower the level of detection risk, as a result,
detection risk is the only risk that is completely a function of the sufficiency of the evidence
gathered by the auditors ‘procedures.

5.6 SUFFICIENT AND COMPETENT EVIDENTIAL MATTER

What constitutes sufficient competent evidential matter? This question arises repeatedly when
planning and performing every audit.
When CPAs are accused of negligence in the performance of an audit, the answer to this
question will often determine their innocence or guilt. To provide auditors with guidelines for
answering this question, the International Auditing Standards Board has issued SAS 31(AU
326) specially addressing competence and sufficiency of audit evidence.
Evidential Matter is any information that corroborates or refutes an assertion. The evidential
matter supporting the assertions in company‘s financial statements consists of:
 The underlying accounting data; and
 All corroborating information available to the auditors.
Auditors use a variety of audit procedures to obtain corroborating information. Here we will
briefly present the most common types of audit procedures.
Physical examination means to view physical evidence of an asset. For example, the auditors
might physically examine plant, equipment, or inventory items to obtain evidence as to their
existence or condition.
Confirmation is the process of obtaining and evaluating a response from a debtor, creditor, or
other party in reply to a request for information about a particular item affecting the financial
statements. Most frequently, confirmation requests (and responses) are in a written form.
Comparison is the process of agreeing or contrasting two-different sources of information.
Auditors often use comparison to test information at various stages of processing within the
accounting system. In describing this process, we need to distinguish tracing and vouching.
 Tracing is the process of establish the completeness of transaction processing by following a
transaction forward through the accounting records. For example the auditors may trace from
a source document to the subsequent recorded transaction.
 Vouching is the process of establishing the occurrence or valuation of recorded transactions
by following a transaction back to supporting documents from a subsequent processing step.
For example, the auditors may select recorded purchase transactions in the purchases journal
and vouch them to supporting evidence such as invoices, paid checks, and receiving reports.
The direction of testing for vouching is the reveres of that used for tracing. Vouching is also
referred to as tracing back.
Re-performance is the process of repeating a client activity. For example, the auditors may
recalculate deprecation, or re-performance bank account reconciliation. Other example of re-
performance includes footing, cross-footing, and extending.

 Footing is the process of proving the totals of a vertical column of figures, such as the
total of daily sales for the month from the sales journal.
 Cross footing, on the other hand, is the process of proving the total of horizontal row. As
an example of cross footing is determining that withholdings plus net pay is equal to
gross pay for an employee in the payroll journal.
 Extending is the process of re computing by multiplication. To extend the client‘s
inventory listing is to multiply the quantities in units by the cost per unit. The resultant
product is the extension.
Observation is the process of viewing a client activity. For example, the auditors may observe
the application of internal control procedures such as the client‘s inventory-taking procedures.
The distinction between physical examination and observation is that for observation to be
performed an activity must be involved. Thus, while physical examination and observation both
may involve inventory, observation would require a client activity (e.g., counting) to be
occurring. In practice, the term observation is sometimes used to refer to both types of
procedures.
Inspection involves a reading or point review of a document or record. For example, the auditors
may inspect a loan agreement. The terms examine, review, read, and scan are often used to
describe applications of the inspection technique.
Reconciliation is used to establish agreement between two sets of independently maintained but
related records. Thus, the ledger account for cash in bank is reconciled with the bank
statements, and the home office record of shipments to a branch office is reconciled with the
records of receipts maintained by the branch.
Inquires are question directed toward appropriate client personnel. The responses to the
questions may be oral or in writing. An example of the inquiry technique is the auditors
‘questioning of the clients controller about the segregation of duties for cash receipts. The
 term inquiry is also sometimes used to refer to the technique of questioning parties’ outsides the
organization. For example, a letter of audit inquiry may be sent to the client‘s lawyer.
Analytical procedures are evaluations of financial information made by a study of expected
relationship among financial and non-financial data. For example, analytical procedures might
involve comparison on the client’s financial ratios for the year under audit with those of prior
years and comparison of client’s financial ratios with industry ratio.

5.7 Types of Audit Evidence

When conducting audits, the auditors gather a combination of many types of evidence to
adequately restrict audit risk. The types of evidence that are gathered during an audit may be
summarized as follows.

1. Physical evidence
2. Documentary evidence
 Documentary evidence created outside the client organizations and transmitted directly
to the auditors.
 Documentary evidence created outside the client organization and held by the client.
 Documentary evidence created and held within the client organization
3. Accounting records as evidence.
4. Evidence from analytical procedures
5. Evidence form computations
6. Evidences provided by specialist
7. Oral evidence
8. Evidence from client representation letters.
1. Physical evidence: Actual Physical examination provides the best evidence of the existence of
certain assets. The existence of property and equipment such as automobiles, buildings, office
equipment, and factory machinery, may be established by physical examination. Similarly, the
amount of cash on hand is verified by counting; and inventory counts are observed.

At first thought, it might seem that physical examination of an asset would be conclusive
verification for all assertions relating to the account; but this is often not true. For example, if the
cash on hand to be counted by the auditors includes checks received from customers, counting
provides no assurance with respect to the valuation of the account; the checks may prove to be
uncollectible when deposited. There is also the possibility that one more worthless check may
have been created deliberately by a dishonest employee as a means of concealing from auditors
the existence of a cash shortage.
The observation of the client‘s count of inventory may also leave some important questions
unanswered. The quality and condition of merchandise or of goods in process are vital in
determining their salability. If the goods counted by the auditors contain hidden defects or are
obsolete, a mere counting of units doesn‘t substantive their balance sheet valuation. CPAs should
be alert to any clues that raise a doubt as to the quality or condition of inventories. Also, they
occasionally may need to arrange for independent specialists to provide information on quality or
condition of inventories.
 In the case of plant and equipment the auditors’ physical examination verifies the existence of
the asset, but gives no proof of ownership. A fleet of automobiles used by salespeople and
company executives, for example, might be leased rather than owned or if owned might be
subject to a mortgage. Also, physical examination does not substantiate the cost of the plant
assets.
In summary, physical examination or observation provides evidence as to the existence of certain
assets, but generally needs to be supplemented by other types of evidence to determine the
ownership, proper valuation, and condition of these assets. For some of assets, such as accounts
receivable or intangible assets, even the existence of the asset cannot be verified through
physical evidence.
2. Documentary Evidence. An important type of evidence relied upon by auditors consists of
documents. The worth of a document as evidence depends in part upon wither it was created
within the company (e.g. sales invoice) or came from outside the company (e.g. a vendor‘s
invoice).
 Some documents created within the company (checks, for example) are sent outside the
organization for endorsement and processing; because of this critical review by outsiders,
these documents are regarded as very reliable evidence.
 In appraising the reliability of documentary evidence, the auditors should consider whether
the document is of a type that could easily be forged or created in its entirety by a
dishonest employee. A stock certificate evidencing an investment in marketable securities is
usually elaborately engraved and would be most difficult to falsify. On the other hand, a
note receivable may be created by anyone in a moment merely by filling in the blank spaces
in one of the standard note forms available at any office supply store.
3. Accounting records as evidence: when auditors attempt to verify an amount in the financial
statements by tracing it back through the accounting records, they will ordinary carry this
process through the ledgers to the journals and vouch the item to such basic documentary
evidence as a paid check, invoice, or other source documents. To some extent, however, the
ledger accounts and the journals constitute worthwhile evidence in themselves.
The dependability of ledgers and journals as evidence is indicated by the extent of internal
control covering their preparation. Whenever possible, subsidiary ledgers for receivables,
payables, and plant equipment should be maintained by persons not responsible for the
general ledger. All general journal entries should be approved in writing by the controller or
other official. If ledgers and journals are produced by a computer system, various computer
controls should be in effect, when controls of this type exist and the records appear to be well
maintained, the auditors may regard the ledgers and journals as affording some support for
the financial statements. In addition to journal and ledgers, other accounting records
providing evidential matter for independent auditors include sales summaries, trial balances,
interim financial statements, and operating and financial reports prepared for management.
4. Evidence from Analytical Procedures. Analytical procedures involve evaluation of
financial statement information by a study of relationships among financial and non-financial
data. SAS 56 9 AU 329), “Analytical Procedures,” Provides guidance and example of
applications of these procedures.
Essentially, the process of performing Analytical Procedures consists of four steps:
1) Develop an expectation of an
account balance:
 2) Determine the amount of
difference from the expectation that can be accepted without investigation
3) Compare the company’s account
balance with the expected account balance.
4) Investigate significant deviations
from the expected account balance.
Techniques used in performing Analytical Procedures range in sophistication from
straightforward comparisons and ratios to complex models involving many relationships and
data from many previous years. Example of Analytical Procedures include comparison of
revenues and expense amounts for the current year to those of prior periods, to industry averages,
to budgeted levels, and to relevant non financial data, such as units produced or hours of direct
labor. A more sophisticated Analytical Procedures might involve the development of a multiple
regression model to estimate the amount of sales for the year using economic and industry data.
In addition, analytical procedures may involve computations of percentage relationship of
various items in the financial statements, such as gross profit percentages. When the
relationships turn out as expected, auditors are provided with evidence that the data being
reviewed are free from material error on the other hand; unusual flections in those relationships
may indicate serious problems in the financial statements and should be investigated fully by the
auditors.
Compression with industry average: Average statistics for various industries are a viable
through such sources as Dun & Bradstreet's key business Ratios and Robert Morris Associates'
annual statement studies. Such average provides a potentially rich source of information for
analytical procedures. Comparisons with industry statistics may alert auditors to classification
errors, improper applications of accounting principles, or other errors in specific items in the
client’s financial statements. In addition, these comparisons may highlight the clients’ strengths
and weakness relative to similar companies, this providing the auditors with a basis for making
constructive recommendations to the client.
Certain problems may be encounter when using industry averages for analytical procedures
because of a lack of comparability among companies and inability to obtain current industry
data. Other companies in the same industry may be larger or smaller, engage in other lines of
business that affect their ratios, or use different accounting methods than does the auditors’
client. In addition, the time required to assemble industry average creates a situation in which the
most recent average are always a tear or so old. Thus, auditors should carefully consider the
extent of comparability and timeliness of the data before drawing conclusions based upon
comparisons with industry averages.
Comparisons with Internal client data: every audit client generates internal information that
may be used in performing analytical procedures. Forecasts, production reports, and monthly
performance reports are but few data sources that may expect to bear predictable relationships to
financial statements amounts. In establishing these relationships, auditors may use dollar
amounts, physical quantities, ratios, or percentages, Separate relationship may be computed for
each division or product line.
Trend analysis is a techniques for identifying consists patterns in the relationships of data from
successive time periods. For example, a review of the clients’ sales for the past three years might
reveal a consistent growth rate of about 7%. This information would assist the auditors in
evaluating the reasonableness of the sales reported in the client’s income statements for the
current year.
5. Computations: another form of audit evidence consists of computations made independently
by the auditors to prove the arithmetical accuracy of the client’s records. Computations differ
from analytical procedures involve the analysis of plausible relationships among financial
data, whereas computations simply verify mathematical process. In its simplest from, an
auditor computation might consists of footing a column of figure in a sales journal or in a
ledger account to prove the column total.
Independent computations may be used to prove the accuracy of such client calculations as
earnings per share depreciation expense, allowance for uncollectable accounts, revenue
recognized on a percentage-of-completion basis, and provisions for federal and state income
taxes. The computation of a client’s liability for postretirement benefits involves actual
assumptions and computation beyond auditors’ area of expertise. Therefore, auditors usually
rely on the services of an actually to compute this liability.
6. Evidence provided by specialists: Auditors may not be experts in performing such technical
tasks as judging value of highly specialized inventory, or making the actuarial computations
to verify liabilities for postretirement benefits. Audit evidence about such matters is best
obtained from qualified specialist. Other examples of audit tasks that may require the use of a
specialist include valuations of works of art or restricted securities, and legal interpretations
of regulations or contracts.
In SAS 73 “using the work of a specialist,” the Auditing Standard Board recognized the
necessity for auditors to consult with experts, when appropriate, as a means of gathering
competent audit evidence. SAS 73 defines a specialist as a person possessing special skill or
knowledge in a field other than accounting and auditing, giving as examples actuaries,
appraisers, attorneys, engineers, environmental consultants, and geologists. Regardless of
whether the specialist is hired by client or by auditors, the provisions of SAS 73 must be
followed.
It is desirable for the specialist counted by the auditors to be unrelated to the client, but it is
acceptable for the specialist to have a relationship with the client. The specialist can even be
employed by the client. However, the auditors should assess the risk that the specialist’s
objectivity might be impaired because of the relationship with the client. If the auditors
believe that specialist’s objectivity might be impaired, they should perform additional
procedures or engage another specialist. In any event, the auditors are responsible for
performing procedures to ascertain the adequacy of the professional qualifications and
reputation of the specialist. This usually involves making inquires about the specialist’s
credentials and experience.
Auditors cannot accept a specialist findings blindly; they must obtain an understanding of the
methods or assumptions used to determine whether the findings are suitable for corroborating
the financial statements. They should also test any data furnished to the specialist by the
client. The auditors should never refer to the specialist in their audit unless the specialist’s
findings are not consistent with the representation in the financial statements, causing the
auditors to modify their opinion.
7. Oral Evidence: Throughout their examination the auditors will ask a great many questions
of the officers and employees of the clients’ organization. These questions cover an endless
range of topics the location of records and documents, the reasons underlying an unusual
accounting procedure, the probabilities of collecting a long past due account receivable.
The answers auditors receive to these questions constitute another type of evidence.
Generally, oral evidence is not sufficient in itself, but it may be useful in disclosing situations
that require investigation or in corroborating other forms of evidence. For example, after
making a careful analysis of all past due accounts receivable, an auditor will normally
discuss with the credit manager the prospect for collection of accounts considered doubtful.
If the opinions of the credit manager are in accordance with the estimates of uncollectible
accounts that have been made independently by the auditor, this oral evidence will constitute
significant support for the conclusions reached. In repeat audits of a business, the auditor will
be in a better position to evaluate the opinions of the credit manager based on the accuracy of
the manager’s estimates in prior years.
8. Evidence from Client Representation Letters: At the conclusion of the audit, the CPAs
obtain from the client a written Representation letter summarizing the most important oral
representations made during the engagement. Many specific items are included in this
representation letter. For example, management usually represents that all liabilities known
to exist are reflected in the financial statements. Most of the representations fall into the
following broad categories;
1. All accounting records, financial data, and minutes of directors’ meetings have been
made available to the auditors.
2. The financial statements are complete and prepared in conformity with generally
accepted accounting principles.
3. All items requiring disclosure (such as loss contingencies, illegal acts, and related party
transactions) have been properly disclosed.
SAS 19(AU, 333) “Client Representation,” requires auditors to obtain a representation letter on
every engagement and provides suggestions as to its form and content. These letters are dated as
of the last day of field work and usually are signed by both the client’s chief executive officer
and chief financial officer.
A client representation letter is a low grade of audit evidence and should never be used as a
substitute for performing other audit procedures. The financial statements already as a substitute
for performing other audit procedures. The financial statements already constitute written
representing by the client; hence, a representation letter does little more than assert that the
original representations were correct.
Although representation letters are not a substitute for other necessary auditing procedures, they
do serve several important audit purposes. One purpose is to remained the client officers of their
primary and personal responsibility for the financial statements. Another purpose is to document
in the working papers the client’s response to the many questions asked by the auditors during
the engagement. Also, a representation by management may be the only evidence available with
respect to management’s future intentions. For example, whether management has both the
ability and the intention to refinance the debt.
Evidence about accounting Estimates
The auditors must be especially careful in considering financial statements accounts that are
affected by estimates made by management (often referred to as accounting estimates),
particularly those for which a wide range of accounting methods are considered acceptable.
Examples of accounting estimates include allowances for loan losses and obsolete inventory, and
estimates of warranty liabilities. Making accounting estimates is management’s responsibility,
and such estimates are generally more susceptible to material misstatement than financial
statements amounts which are more certain in amount. SAS 57 (AU 342), “auditing accounting
Estimates,” requires the auditors to determine that (a) necessary estimates have been developed,
(b) the accounting estimates are reasonable, and (c) the accounting estimates are properly
accounted for and disclosed.
Determining whether all necessary estimates have develop and accounted for properly steps (a)
and (c) requires a knowledge of the client’s business and the applicable generally accepted
accounting principles. When evaluating the reasonableness of accounting estimates (step (b), the
auditors may use one or more of the following three basic approaches.
1. Reviewing and testing management’s process of developing the estimates this will often
evaluating the reasonableness of the steps performed by management.
2. Independently developing an estimate of the amount to compare to managements estimates.
3. Reviewing subsequent events or transactions bearing on the estimates, such as actual
payments of an estimated amount made subsequent to year-end.
The wide range of potential accounting methods complicates transactions involving accounting
estimates Pensions leases and long-term constriction contracts are just a few examples of
transactions with complex accounting methods that vary depending on the nature of the
agreements and the specific circumstances. While it sounds as basic as to almost be trivial, it is
essential that the auditors understand the transactions in which their clients are involved. In
practice, this requirement is onerous since the auditors may be involved in a variety of audits,
requiring knowledge of a host of different accounting methods and estimates.
The cost factor may preclude gathering the strongest possible form of evidence and necessitate
the substitution of other forms of evidence that are of lesser quality, yet still satisfactory. For
example, assume that the auditors obtain to be corresponding directly with the customer. What
evidence should the auditors obtain to be satisfied that the note is authentic and will be paid at
maturity? One option 9is for auditors to correspond directly with the customer and obtain written
confirmation of the customer issued the note and regards it as a valid obligation. Second, the
auditors might test the collectibles of the note by obtaining a credit report on the customer from
Dun and Bradstreet, Inc., or from a local credit association. They might also obtain copies of the
customers most recent financial statements accompanied, if possible, by the opinion of an
independent CPA. To carry our illustration to an extreme, the auditors might obtain permission
to make an audit of the financial statements of the customer. The cost of conducting this separate
audit could amount to more than the note receivable the auditors wished to verify.
The point of this illustration is that auditors do not always insist upon obtaining the strongest
possible evidence. They do not upon obtaining evidence that is sufficient under the
circumstances. The greater the risk of material misstatement of the item to be verified, the
stronger the evidence required by the auditors, and the greater the cost they may be willing to
incur in obtaining it.
 CHAPTER SIX
AUDIT REPORTS

6.1 STANDARDS OF REPORTING

1. The report shall state whether the financial statements are presented in accordance with
general accounting principles.
2. The report shall identify those circumstances in which such principles have not been
consistently observed in the current period in relation to the preceding period.
3. Informative disclosers in the financial statements are to be regarded as reasonably adequate
unless otherwise stated in the report.
4. The report shall either contain an expression of opinion regarding the financial statements,
taken as a whole, or an assertion to the effective that an opinion cannot be expressed.
When an overall opinion cannot be expressed, the reasons therefore should be stated. In all cases
where an auditor‘s name is associated with the financial statements, the report should contain a
clear-cut indication of the character of the auditor‘s examination, if any, and the degree of
responsibility he/she is taking.
The four reporting standards establish some specific directive for preparation of the auditor‘s
report. The report specifically state where the financial statements are in conformity with
generally accepted accounting principles. The report must contain an opinion on the financial
statements as a whole, or must disclaim an opinion. Consistency in the application of generally
accepted accounting principles and adequate informative disclosure in the financial statements is
to be assumed unless the audit report states otherwise.
Generally accepted Accounting Principles: In preparing his/her report, the auditor
should state whether the financial statements are in accordance with generally accepted
accounting principles or not. Generally accepted accounting principles, as used in the standard
of reporting, indicate the application of such principles in the preparation of financial statements.
But you have to note that the auditor should not state the financial statements are in
accordance with GAAP if they are not actually so.
Consistency: the auditor should demonstrate in his/her report a consistent application of
GAAP in the preparation of financial statements. Consistency as it is applies to standards of
reporting requires the auditor to state in his/her report if there is a change in the accounting
principles that materially affect the comparability of the financial statements.

Informative Discloser: the auditor has to evaluate whether all information that will have
material effect on the statements is disclosed.
Expressing opinion: the auditor‘s opinion indicates whether the financial statements are
fairly presented or not. It is for this reason that the standard of reporting requires the auditor to
express his/her opinion on the financial statements based on his/her findings. If the auditor is
unable to from opinion due to various reasons, she/he has to state the reasons clearly.
Expressing an independent and expert opinion on the fairness of financial statements is the most
frequently performed attestation service rendered by the public accounting profession. The fourth
standard of reporting states:

The (auditor’) report shall either contain an expression of opinion regarding his/her
financial statements, taken as a whole, or an assertion to the effect that an opinion cannot
be expressed. When an overall 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 auditors’ work, if any,
and the degree of responsibility the auditor is taking.
 The auditors’ standard report meets this standard by (a) stating that the audit was performed in
conformity with generally accepted auditing standards and (b) expressing an opinion that the
clients financial statements are presented fairly in conformity with generally accepted accounting
principles. However, if there are material deficiencies in the clients’ financial statements or
limitations in the audit, or if there are other unusual conditions about which the readers of the
financial statements should be informed, auditors cannot issues the standard report. Instead, they
must carefully modify their report to make these problems or conditions known to users of the
audited financial statements.

6.1.1 FINANCIAL STATEMENTS

 The reporting phase of an audit begins when the independent auditors have completed their
fieldwork and they have proposed any necessary adjustments to the client.
 Before drafting their report, the auditors must review the client prepared financial statements
form and content, or draft the financial statements on behalf of the client.
The financial statements on which the independent auditors customarily report are the balance
sheet, the income statements, the statements of retained earnings, and the statements of cash
flows. Often, the statement of retained earnings is combined with the income statement. In some
cases, the retained earnings statements may be expanded to a statement of stockholders’ equity.
Financial statements generally are presented in comparative form for the current year and the
preceding year and are accomplished by explanatory notes. The financial statements for a present
corporation usually are consolidated with those of the subsidiaries.

6.1.2 FINANCIAL STATEMENTS DISCLOSURES

 The purpose of notes to financial statements is to achieve adequate disclosure when information
in the financial statements is insufficient to attain this objective.
 Although the notes, like financial statements themselves, are representations of the client, the
independent auditors generally assist in drafting the notes.
 The writing of notes to financial statements is a challenging task because complex issues must be
summarized in a clear and concise manner.
 Adequate disclosure in the notes to the financial statements is necessary for the auditors to issue
an unqualified opinion on the financial statements.
The financial accounting standards Board, the Government Accounting Standards Board, and the
Securities and Exchange Commission have issued numerous pronouncements that have added
extensive disclosure requirements. Examples of note disclosure requirements that have become a
part of the basic financial statements include the disclosure of significant accounting policies,
accounting changes, loss contingencies, and lease and pension information.

In addition to the note disclosures that are part of the basic financial statements, many clients are
required by the FASB, the GASB, or the SEC to present supplementary information. Such
information, while not a required part of the basic financial statements is required to be presented
as unaudited supplementary scheduled accompanying the financial statements. As an example,
certain companies are required to disclose selected interim financial data with their annual
financial statements.

In evaluating financial reporting disclosures, the auditors should keep in mind that disclosures
are meant to supplement the information in the financial statement and not to correct
improper financial statements presentation. Thus, a note or supplementary schedule, no matter
how skillfully drafted, does not compensate for the erroneous presentation of an item in the
financial statements.

6.2 TYPES OF AUDIT REPORT

The end product of a financial statements audit is an auditor’s report through which the auditor
expresses his/her opinion. There are four types of audit reports; namely, Unqualified, Qualified,
Adverse, and Disclaimer.

1. An unqualified opinion—standard report. This report represents a clean opinion” and may
be issued when the two conditions listed above have been met, and when no conditions
requiring explanatory language exist.
2. An unqualified opinion—with explanatory language added to report. This is an audit
report with an unqualified opinion but with explanatory language resulting from certain
circumstances. Examples of such circumstances are those in which other auditors have
performed a portion of the audit, or when major uncertainties exist with respect to the
company being audited.
3. A qualified opinion: A qualified opinion states that the financial statements are presented
fairly “except for” the effects of some matter. Qualified reports are issued when the financial
statements depart materially from generally accepted accounting principles, or when
limitations are placed on the scope of the auditors procedures. The problems, while they are
materials, do not overshadow the overall fairness of the statements.
4. An adverse opinion: An adverse opinion states that the financial statements are not a fair
presentation. Auditors will issues an adverse opinion when the deficiencies in the financial
statements are so significant that the financial statements taken as a whole are misleading. All
significant reasons for the issuance of an adverse opinion should be set forth in an explanatory
paragraph.
5. A disclaimer of opinion: A disclaimer of opinion means that due to a significant scope
limitation (or very major uncertainties), the auditors were unable to form an opinion on the
fairness of the financial statements. A disclaimer is neither a positive nor a negative opinion;
it simply means that the auditors do not have an adequate basis for expressing an opinion.
6.3 EXPRESSION OF AN OPINION (CONTENTS OF AUDIT REPORT)
The auditors’ Standard Report
Before continuing, let us mention a few details about this report.
It has a title that includes the word “independent.”
The first paragraph is referred to as the introductory paragraph. It clearly indicates that (1) the
financial statements have been audited; (2) the financial statements are the responsibility of
management, and (3) the auditors’ responsibility is to express an opinion on them.
The second paragraph, which describes the nature of an audit, is called the scope paragraph.
Finally, the opinion paragraph presents the auditors’ opinion on whether the financial
statements are in conformity with generally accepted accounting principles.

Notice that the report is signed with the name of the CPA firm, not the name of an individual
partner in the firm. This signature stresses that it is the firm, not an individual that takes
responsibility for the auditors’ report. If the CPA performing the audit is a sole practitioner, the
report will be signed with the CPAs personal signature. In addition, a sole practitioner should use
the word I instead of we in the auditor’s report. Also notice the date under the signature. This
date is normally the last day of fieldwork—that is, the date upon which the auditors conclude
their investigative procedures. This date is quite significant, because the auditors have a
responsibility to perform procedures to the date to search for any subsequent events that may
affect the fairness of the clients’ financial statements.

Independent Auditors’ Reports

To the Board of Directors and Stockholders
XYZ Company
We have audited the accompanying balance sheet of XYZ Company as of December
31,19XX, and the related statements of income, retained earnings, 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 generally accepted auditing standards. Those
standards require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of 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 statements
presentation. We believe that our audit provides a reasonable basis for our opinion .
In our opinion, the financial statements referred to above present fairly, in all material
respects, the financial position of XYZ company as of December 31,19XX, and the results of
its operations and its cash flows for the year then ended in conformity with generally
accepted accounting principles.
Blue, Gray and Company
Los Angeles, Calif.
Certified public Accountants
February 26,19XX
An unqualified auditor’s report may be issued only when the following conditions have been
met:

1. The financial statements are presented in conformity with generally accepted accounting
principles, including adequate disclosure:
2. The audit was performed in accordance with Generally Accepted Auditing standards,
including no significant scope limitations preventing the auditors from gathering the
evidence necessary to support their opinion.
When considered material, departure from either of those conditions results in a situation in
which a report that is other than unqualified is required. Additionally, when certain other
conditions exist, the auditors add explanatory language to the standard report, but express an
unqualified opinion.

Materiality
Auditors must qualify their report whenever there are material deficiencies in the clients’
financial statements; when the deficiencies are immaterial, an unqualified report may be
issued.

Accordingly, auditors must exercise professional judgment to evaluate the materiality of any
such departures. At this stage of the audit, the auditors can consider both the quantitative and
qualitative effects of the deficiencies. For example, a related party transaction of a relatively
small amount may be considered to be material.

Auditors are required to issue an adverse opinion when the deficiencies in financial
statements are “so significant” that a qualified opinion would be inappropriate. A qualified
opinion is considered insufficient

 When the deficiencies in financial statements are material that they overshadow the
fairness of the financial statements viewed as a whole. For example, misstatements that
make an insolvent business appear to be solvent would be considered sufficiently
material as to be overshadowing the fairness of the statements viewed as a whole.
The distinction between problems that are material but not overshadow the fairness of the
statements and those problems that do overshadow the fairness of the statements is again a
matter of professional judgment. In our following discussions, it will not be practical to present
sufficient detail for readers to make these judgments.

 Therefore, we will use the term material to describe problems that are sufficient to
require qualification of the auditors’ report, but which do not overshadow the fairness
of the statements.
 Problems overshadowing the fairness of the statements will be described as “very
Material” or as causing the statements to be “substantially misleading.”
1) The Unqualified report
Auditors express an unqualified opinion on the clients financial statements

 They have no material exceptions as to the fairness of the application of accounting

principles, and
 There have been no unresolved restrictions on the scope of their engagement.
The unqualified opinion is, of course, the most desirable report from the client’s point of view.
The client usually will make any necessary adjustments to the statements to enables the auditors
to issue this type of opinion.

2) Explanatory Language Added to the unqualified opinion

Under certain circumstances auditors add explanatory language to the standard report, even when
issuing an unqualified opinion. Adding the additional language is not regarded as a qualification
because it does not lessen the auditors reporting responsibility for the financial statements.
Rather, the language merely draws attention to a significant situation. Auditors add explanatory
language to an unqualified opinion
 To indicate that a part of the audit was performed by other auditors
 To refer to an uncertainty that could have a material impact on the financial statements,
 To indicate an inconsistency in the application of accounting principles,
 To emphasize a matter, and
 To indicate a justified departure from officially recognized accounting principles.
Part of the Audit performed by Other Auditors : - On occasion it may be necessary for the
principal auditors of a company to rely upon another CPA firm to perform a portion of the audit
work. The most common situation in which CPAs rely upon the work of other auditors is in the
audit of consolidated entities. If certain subsidiaries have been audited by other CPA firms, the
auditors reporting on the consolidated parent company will usually decide to rely upon the work
of those other CPAs rather than conduct another audit of the subsidiaries.

When more than one CPA firm participates in an engagement, the auditor’s report is issued by
the Principal Auditors—that is, by the CPA firm that did the majority of the audit work and has
an overall understanding of the financial statements. The principle auditors have to basic
alternative in wording their report:

1. Make no reference to the Other Auditors : if the principal auditors make no reference in their
report to the portions of the engagement performed by the other CPAs, the principal auditors
assume full responsibility for the other auditors work. This approach is usually followed
when the other CPA firm is well known, or when the principle auditors hired the other
auditors. When no reference is made, the principal auditors should consider
 Visiting the other auditors,
 reviewing the other auditors audit programs and working papers, or
 Performing additional audit procedures.
 If the principal auditors elect to make no reference, they may issue the standard auditor’s report
with no additional working.
2. Make Reference to the other auditors: make reference to the work done by other auditors
divides the responsibility for the engagement among the participating CPA firms. This type of
report is called a shared responsibility opinion, even though it is signed only by the principal
auditors. A shared responsibility opinion is usually issued when the other auditors were
engaged by the client, rather than by the principal auditors. A shared responsibility opinion
should indicate the portion of the engagement performed by the other auditors. A typical
shared responsibility opinion is illustrated below, with emphasis on the special wording added
to the standard report.

Independent Auditors Reports

To the Board of Directors and Stockholders
XYZ company:
We have audited the consolidated balance sheet of XYZ Company as of December 31,
19XX, and the related statements of income, retained earnings, and cash flows for the year
than ended. These financial statements are the responsibility of the Company’s management.
Our responsibility is to express an opinion on those financial statements based on our audit.
We did not audit the financial statements of sub company, wholly owned subsidiary, which
statements reflect total assets of $______ as of December 31, 19XX and total revenues of
$____ for the year then ended. These statements were audited by other auditors whose report
has been furnished to us, and our opinion, insofar as it relates to the amounts included for sub
Company, is based solely on the report of the other auditors.
We conducted our audit in accordance with generally accepted auditing standards. Those
standards require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of 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 principle used and significant
estimates made by management, as well as evaluating the overall financial statement
presentation. We believe that our audit and the report of other auditors provide a reasonable
basis for our opinion.
In our opinion based on our audit and the report of other auditors, the consolidated
financial statements referred to above present fairly, in all martial respects, the financial
position of XYZ company as of December 31,19XX, and the results of its operations and its
cash flows for the year then ended in conformity with generally accepted accounting
principles.
Blue, Gray and Company
Los Angeles, Calif.
Certified public Accountants
February 26,19XX

Uncertainties: substantial uncertainty as to the outcome of a contingency affecting the clients’

financial statements may require the auditors to add an explanatory paragraph to their audit
report to indicate the existence of the uncertainty.
In accordance with FASB statements No. 5, contingencies that are probable and can be
reasonable estimated should be accrued in the financial statements. Failure to do so is a departure
from generally accepted accounting principles that leads to a qualified or an adverse opinion by
the auditors.

It is when the contingency is reasonably possible that the auditor’s should consider adding an
explanatory paragraph to their unqualified opinion, based on their judgment on the materiality of
the contingency and the probability of unfavorable outcome.

When a material loss is probable, but management is unable to estimate it, the auditors also
should consider adding an explanatory paragraph to their unqualified report. Finally, no
explanatory paragraph is required for a loss with a remote likelihood of occurrence since FASB
Statements No 5 does not require disclosure of such contingent losses.

A modification of the report for uncertainty is appropriate even though the client has properly
disclosed contingencies in conformity with FASB Statement No. 5. If such disclosures have not
been made, a departure from generally accepted accounting principles also exists, and qualified
or an adverse opinion may be appropriate.

The standard report modified for uncertainty includes a fourth paragraph following the opinion
paragraph that described the uncertainty. The following is an example of such a paragraph.

As discussed in Note X to the financial statements, the company is currently a defendant in a

number of legal proceedings and may in the future be a defendant in additional, related
proceedings expected to be filed alleging damages due to products sold in the past. The
company has filed a legal action against its insurers who have disputed liability under various
company insurance policies. The ultimate outcome of the current and expected future
lawsuits cannot presently be determined. According, no provision for any liability that may
result upon adjudication has been made in the accompanying financial statements.

Questions about A Company’s Going Concern Status: A special type of significant

uncertainty concern the ability of a client company to continue as a going concern. Under
generally accepted accounting principles, both assets and liability are recorded and classified on
the assumption that the company will continue to operate. Assets, for example, may be presented
at amounts that are significantly greater than their liquidation values.

SAS 59 (AU 341), “the auditors Consideration of an entity’s Ability to Continue as a Going
Concern,” describes the auditors’ responsibilities for evaluating an entity’s ability to continue as
a going concern. Although the auditors are not required to perform procedures specifically
related to the going concern assumptions, they must evaluate the results of the normal procedures
performing in planning, gathering evidential matter, and completing the audit. Conditions that
may cause the auditors to question the going concern assumption include negative cash flows
from operations, defaults on loan agreements, adverse financial ratios, work stoppages, and legal
proceedings. When such conditions or events are identified, the auditors should gather additional
information and consider whether management’s plans for dealing with the conditions are likely
to negate the problem. If, after evaluating all the information and managements plans substantial
doubt still exists about the company’s ability to continue as a going concern for a period of one
year from the balance sheet date, the auditors should modify their report by adding a final
paragraph such as the following:

The companying financial statements have been prepared assuming that XYZ company will
continue as a going concern. As discussed in Note X to the financial statements, XYZ
company has suffered recurring losses from operations and has a net capital deficiency that
raises substantial doubt about the entity’s to continue as a going concern. Management’s
plans in regard to these matters are also described in Note X. The financial statements do not
include any adjustments that might result from the outcome of this uncertainty.

GAAP Not Consistently Applied. If a client company makes a change in accounting principle,
the nature of, justification for, and effect of the change are reported in a note to the financial
statements for the period in which the change is made.

Any such change having a material effect upon the financial statements will also require
modification of the auditor’s report, even though the auditors are in full agreement with the
change. Changes in accounting estimates need not be reported in the auditor’s report.

Changes from one generally accepted accounting principle to another generally accepted
accounting principle, when justified; do not result in qualification of auditors’ report. The report
is merely modified to highlight the lack of consistent application of acceptable accounting
principle.

A report modified for a change to an acceptable accounting principle includes an additional

paragraph following the opinion paragraph, such as the one illustrated below.

As discussed in note 2 to the financial statements, XYZ Company changed its method of
computing deprecation in 19X2.

In the preceding example, Note 2 to the financial statements would describe the nature and
justification for the change in methods of computing depreciation, as well as the effects on the
financial statements.

Emphasis of a Matter: auditors also may issue an unqualified opinion that departs from the
wording of the standard report in order to emphasize some element within the client’s financial
statements. For example, the auditors may add an additional paragraph to their unqualified
opinion calling attention to a significant related-party transaction described in a note to the
financial statements. The paragraph may either precede or follow the opinion paragraph.

Justified Departures from Officially Recognized accounting principles FASB and GASB
Statements and Interpretations and ABP Opinions have the status of authoritative body
pronouncements. They represent the highest level of generally accepted accounting principles. In
unusual circumstances, however, auditors’ may consider it appropriate for the financial
statements to depart from these pronouncements in order to achieve the more important objective
of a fair presentation. In such cases, the CPAs may still issue an unqualified report, but they must
disclose the departure in an explanatory paragraph either before or after the opinion paragraph.
Such reports are sometimes called “203 reports,” because rule 203 of the AICPA code of
professional conduct officially recognizes that in unusual circumstances a departure from
authoritative accounting principle may be justified. The coded of professional conduct was
discussed in chapter 2.

3) Qualified Opinions
A qualified opinion expresses the auditors’ reservations about fair presentation in some areas of
the financial statements. The opinion states that except for the effects of some deficiency in the
financial statements, or some limitation in the scope of the auditors’ examination, the financial
statements are presented fairly. All qualified reports include a separate explanatory paragraph
before the opinion paragraph disclosing the reasons for the qualification. The opinion paragraph
of a qualified report includes the appropriate qualifying language and a reference to the
explanatory paragraph.

The maturity of the exception governs the use of the qualified opinion. The exception must be
sufficiently significant to warrant mentioning in the auditors’ report, but it must not be so
significant as necessitate a disclaimer of opinion or an adverse opinion. Consequently, the
appropriateness of a qualified opinion in the event of a significant exception is a matter for
careful professional judgment by the auditors.

Departure from a Generally Accepted Accounting Principle: the auditors sometimes do not
agree with the accounting principles used preparing the financial statements. Usually, when the
auditor’s objects icons are carefully explained, the client will agree to change the statement in an
acceptable manner. If the client does not agree to make the suggested changes, the auditors will
be forced to qualify their opinion (or if the exception is very material, to issue an adverse
opinion).

When the report is qualified, the introductory and scope paragraphs of the standard report are
unaffected. The modification involves adding an explanatory paragraph following the scope
paragraph and qualifying the opinion paragraph. The qualifying language used in the opinion
paragraph always begins with the term except for. Following is an example of the explanatory
and opinion paragraphs of an audit report for a departure from generally accepted accounting
principles.

The company has excluded from property and debt in the accompanying balance sheet certain
lease obligations that, in our opinion, should be capitalized in order to conform with generally
accepted accounting principles. If these lease obligations were capitalized, property would be
increased by $____, long-term debt by $___, and retained earnings by increase (decreased)
by $____, and $____, respectively, for the year then ended.
In our opinion, except for the effects of not capitalizing lease obligations, as discussed in
the preceding paragraph, the financial statements referred to above present fairly, in all
material respects the financial position of XYZ Company as of December 31,19XX, and the
results of its operations and its cash flows for the year than ended in conformity with
generally accepted accounting principles.

The third standard of reporting address a particular type of departure from generally accepted
accounting principles—inadequate disclosers—and states that:

Informative disclosures in the financial statements are to be regarded as reasonability

adequate unless otherwise stated in the (auditors) report.

Thus auditors may need to issue a qualified or adverse opinion if they consider the discloser in
accounting principles—inadequate.

SAS 32 (AU 431), “Adequacy of Disclosure in Financial Statements,” requires auditors to

include the omitted disclosure in an additional paragraph of their report, if it is practicable to do
so. The word practicable in this context means that the information can reasonably be obtained
and that its inclusion in the report would not cast the auditors in the role of the preparer of the
information. For example, the omission by the client of the statements of cash flows from an
otherwise complete set of financial statements would not cause the auditors to include the
statements in their report, but would result in a qualified opinion.

Obviously a client who is reluctant to make a particular discloser would rather make the
disclosure in a note than have it highlighted in the auditors’ report. Therefore, very few auditors’
reports actually are qualified because of inadequate disclosure. Instead, the requirements of SAS
32 usually convince the client to include the necessary disclosure among the notes to the
financial statements.

Scope Limitation: Limitation in the scope of an audit arise when the auditors are unable to
perform an essential audit procedure. Limitation may be due either to circumstances surrounding
the audit for example, the auditors were engaged too late.

In this situation, the professional standards require issuance of a qualified opinion. The basis of
the qualification is that when a balance sheet and statement of income is presented, a statement
of cash flows is required. However, if only a balance sheet or a statement of income is presented,
a statement of cash flows is not required in the year to observe the client’s beginning inventory
or due to the client (for example, the client refuses to allow the auditors to send confirmations).

When a circumstances-imposed scope limitation is involved, the auditors attempt to perform

alternative procedures to gather sufficient competent evidential matter. If such evidential matter
is collected and the auditors believe that it is sufficient, an unqualified opinion may be issued. In
situations in which alternative procedures do not provide sufficient evidence, the auditors will
either quality the opinion to reflect the scope limitation or disclaim an opinion. The qualifying
language and the explanatory paragraph (which follows the opinion paragraph) that distinguish
the qualified report from the auditors’ standards report are emphasized below.

Except as discuss in the following paragraph, we conducted our audit in accordance with
generally accepted auditing standards. Thus standards require that we plan and perform, the
audit to obtain reasonable auditing about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting the amount
and disclosers in the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made may management, as well as evaluating the
overall financial statement presentation. We believe that our audit provides a reasonable basis
for our opinion.
We were unable to obtain audited financial statements supporting the company’s
investments in foreign affiliate stated as $____, or its equity in earnings of that of $_____,
which is included in net income, as described in Note 8 to the financial statements; nor were
we able to satisfy ourselves as to the carrying value of the statement in the forging affiliate or
the equity in earnings by others auditing procedures.
In our opinion, except for the effects as such adjustment, if any, as might have been
determined to be necessary had we been able to examine evidence regarding the forging
affiliate investment and earnings, the financial statements referred to above present fairly in
all material respects, the financial position of XYZ Company as of December 31, 19XX, and
the result of its operations and its cash flows for the year then ended, in conformity with
generally accepted accounting principles.

If a circumstance-imposed scope limitation affects a “very material” portion of the financial

statements or if the client imposes a significant limitation, qualified opinion would normally be
considered inappropriate, and the auditors should issue a disclaimer of opinion.

Two or More Qualification

An auditors’ report may be qualified two or more situations. For example, the report may be
qualified because of both a scope limitation and a separate problem involving accounting
principles. The wording of such a report would include the appropriate qualifying language and
explanatory paragraphs for both types of qualifications.

Note that even through this may be the “fault” of the client; it is considered circumstance-
imposed limitation because the client is not refusing to allow the auditor to perform a procedure
which is possible to perform.

When there are several situations requiring the qualification of an opinion, the auditors should
consider the cumulative effects of these problems. If the effect of the problems is to overshadow
the fairness of the statements viewed as a whole or to prevent the auditors from forming an
overall opinion, a qualified opinion would be inappropriate. In such cases, the auditors should
issue either an adverse opinion or disclaimer of opinion, depending upon the circumstances.

4) Adverse Opinions
An Adverse Opinion is the opposite of an unqualified opinion; it is an opinion that the financial
statements do not present fairly the financial position, result of operations, and cash flows of the
client, in conformity with generally accepted accounting principles. When the auditors express
an adverse opinion, they must have accumulated sufficient evidence to support their unfavorable
opinion.

The auditors should express an adverse opinion if the statements are so lacking that a qualified
opinion would not be warning enough. Whenever the auditors issue an adverse opinion, they
should disclose in a separate paragraph of their report the reasons for the adverse opinion and
the principal effects on the financial statements of the matters causing the adverse opinion, if the
effects can be determined.

Thus, an audit report that expresses an adverse opinion generally includes

 standard introductory and scope paragraphs,

 one or more explanatory paragraphs preceding the opinion paragraph and
describing the reasons for the adverse opinion, and
 An opinion paragraph.
Because the reasons for an adverse opinion are usually lengthy and complex, we illustrate only
the opinion paragraph below:

In our opinion, because of the effects of the matters discussed in the preceding paragraph, the
financial statements referred to above do not present fairly, in conformity with generally
accepted accounting principles, the financial position of XYZ company as of December 31,
19X5, or the results of its operations or its cash flows for the year then ended.

Adverse opinions are rare because most clients follow the recommendations of the independent
auditors with respect to fair presentation of financial statements.

One possible sources of adverse opinion is the actions of regulatory agencies that require
organizations to use accounting practices that are not in accordance with generally accepted
accounting principles.
5) Disclaimer of opinion
A disclaimer of opinion is no opinion. In an audit engagement, a disclaimer is required when
substantial scope restrictions or other condition preclude the auditor’s compliance with
generally accepted auditing standards.

Substantial Circumstance-Imposed Scope Restrictions: if a scope restriction is so severe that

qualified opinion is inappropriate, the auditors should issue a disclaimer of opinion. This might
happen, for example, if the auditors were engaged after year-end and the client did not take a
physical inventory.

A disclaimer issued because of a scope limitation will omit the scope paragraph of the standard
report and will include an explanatory paragraph describing the scope limitation in its place.

The wording of the opinion paragraph will change considerably; because the auditors are not
expressing an opinion—rather, they are saying that they have no opinion. A disclaimer of
opinion is illustrated bellow:

We were engaged to audit the accompanying balance sheet of XYZ company as of

December 31, 19X2, and the related statements of income, retained earnings, and cash flows
for the year then ended. These financial statements are the responsibility of the company’s
management.
The company did not make a count of its physical inventory, sated in the accounting financial
statements at $_____ as of December 31, 19X2. Further, evidence supporting the cost of
property and equipment acquired prior to December 31, 19X1, is no longer available. The
company‘s records do not permit the application of other auditing procedures to inventory or
property and equipment.
Since the company did not take physical inventory and we were not able to apply other
auditing procedures to satisfy our selves as to inventory quantities and the cost of property
and equipment, the scope of our work was not sufficient to enable us to express, and we do
not express, an opinion on these financial statements.

Disclaimers of opinion because of scope restriction are relatively rare. The auditors should be
able to foresee these types of problems in the planning stage engagement. The client usually will
not want to incur the cost of an audit if it is apparent from the start that the auditors must issue a
disclaimer of opinion.

Scope Restrictions Imposed by the Client: the professional standards state that when client-
imposed restriction significantly limit the scope of the audit, the auditor generally should
disclaim an opinion on the financial statements. Two reasons exist for this requirement.

 First, a disclaimer is relatively useless to the client. Therefore, the fact that the auditors
may have to issue a disclaimer is substantial deterrent to the client imposing a scope
restriction in the first place.
 Second, a client who imposed scope restrictions up on the auditors apparently has
something to hide. An audit must be undertaken with an atmosphere of trust and
cooperation. If the client is attempting to conceal information, no audit can insure that all
of the problems have been brought to light.
Disclaimer because of uncertainty: an unqualified opinion with an explanatory paragraph is
generally appropriate for a material uncertainty that is described adequately in notes to the
client’s financial statements. However, the standards allow the issuance of a disclaimer of
opinion because of a material uncertainty, including one about the company’s ability to continue
as a going concern.

Other Disclaimers issued by CPAs: in this section, we have discussed only those disclaimers of
opinion issued in audit engagements. CPA firms issue dulcimers of opinion in many other types
of engagements.

Disclaimers are not Alternatives to Adverse Opinions.

A disclaimer can only be issued when the auditors do not have sufficient information to form an
opinion on the financial statements.

If the auditors have already formed an opinion that the financial statements are not a fair
presentation, the disclaimer cannot be used as a way to avoid expressing an adverse opinion.

In fact, even when auditors issue a disclaimer of opinion, they should express in explanatory
paragraphs of their report any reservations they have concerning the financial statements.

These reservations include any material exception as to generally accept accounting principles,
including disclosure. In short, the issuance of a disclaimer can never be used to avoid warring
financial statements users about problems that the auditors known to exist in the financial
statements.