CHAPTER ONE

Nature, Scope, Objectives and Attestation Service of Auditing

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 Introduction
The word “audit” was derived from the Latin word “auditus” the
past participle stem of audire meaning” to hear”, “listen” or “give
credence to”, so called because originally the accounts were read
aloud.
In ancient times it was the practice to check of the accounts of an
estate, domain or manor by having such accounts called out by those
who compiled them to those in authority.
Reliable information that is necessary in order to help managers,
investors, creditors, and regulatory agencies to make informed
and wise decisions.
Auditing plays an important role in this aspect by providing
objectively determined and independent reports on the reliability of
financial information.
 Auditing is important to both private and public enterprise.
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 Definition of Auditing
• Auditing is the accumulation and evaluation of evidence
about information to determine and report on the degree
of correspondence between the information and
established criteria.
• Evidence is any information used by the auditor to
determine whether the information being audited is
stated in accordance with the established criteria.
• To satisfy the purpose of the audit, auditors must obtain
a sufficient quality and volume of evidence.
• Auditors must determine the types and amount of
evidence necessary and evaluate whether the information
corresponds to the established criteria.
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 Definition of Auditing
• In addition to evidence, there must be information in a
verifiable form and some standards (criteria) by which the
auditor can evaluate the information.
• Auditors routinely perform audits of quantifiable
information, including companies’ financial statements and
individuals’ federal income tax returns.
• The criteria for evaluating information also vary depending
on the information being audited.
• In the audit of historical financial statements by CPA firms,
the criteria may be International Financial Reporting
Standards (IFRS), Internal Revenue Service (IRS), Internal
Control System (ICS).
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 Definition of Auditing

• For an audit of internal control over financial

reporting, the criteria will be a recognized framework
for establishing internal control, such as Internal
Control—Integrated Framework issued by the
Committee of Sponsoring Organizations of the Tread
way Commission (widely known as COSO).

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 Definition of Auditing
• For the audit of tax returns by the Internal Revenue
Service (IRS), the criteria are found in the Internal
Revenue Code.
• In an IRS audit of Boeing’s corporate tax return, the
internal revenue agent uses the Internal Revenue
Code as the criteria for correctness, rather than
GAAP.
• Auditors also audit more subjective information, such
as the effectiveness of computer systems and the
efficiency of manufacturing operations. However,
subjective information is difficult to auditors.

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 Definition of Auditing

• Audit is an independent examination of financial

statements of an entity that enables an auditor to
express an opinion whether the financial statements
are prepared (in all material respects) in accordance
with an identified and acceptable financial reporting
framework (criteria) (e.g. GAAP, international or the
national standard of a particular country and
national legislations).
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 Cont.…
The phrases used; “to express the auditor’s opinion”
means that the financial statements give a true and fair view
or have been presented fairly in all material respects.
True and fair presentation means that the financial
statement are prepared and presented in accordance with
the requirements of the applicable International Financial
Reporting Standards (IFRS) or GAAP and local
pronouncements/legislations.
 Note that the auditor does not certify the financial statements or
guarantee that the financial statements are correct, he reports that in
his opinion they give a ‘true and fair view’, or present fairly the
financial position.
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 Characteristics of audit
 An auditor involves in examination of financial
statements.
 The end result of an audit is an opinion to assist the user
of the financial statements.
 The auditor’s opinion makes reference to “true and fair”
or “fair presentations” but “true and fair” is again a
matter of judgment. It is not precisely defined for the
auditor.
 The auditor should be independent of the entity, and
the auditor has no significant personal interest in the
entity.

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 Characteristics of audit
 The goal, or objective, of the auditing is communicating
the results to interested users.
The communication of the auditor’s opinion is called
attestation, or the attest function. In an audit, this
attestation is called the ‘audit report’.

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 Economic demand for Audit

 Control mechanism: audits were important control

mechanisms for 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.
By: Mulu.M

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 Economic demand for Audit
• 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.
• It is likely that the manager will not act in the best
interest of the owner.
• Thus, the need for Independent (non-pertain) opinions or
view is necessary to resolve such conflicts.
• To reduce damaging Consequences: the information
provided by accounting or accountant is must be verified
by the audit or auditors.

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 Economic demand for Audit
• To simplify complexity
• Regulatory requirements: many business laws,
memorandum of association and government regulation,
make requirements’ annual audits.
• For example the security exchange commission (SEC) in
the United States of America; the Commercial Code of
Ethiopia (1966), and latter the Public Financial Regulation
of Proclamation 163/1999 in Ethiopia make the filing of
audited financial statements annually.
• Disaster Prevention and Preparedness Commission
(DPPC) requires NGOs to prepare and submit their annual
financial statements.
• Thus, compliance requirements create a very large demand
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auditing services. By: Mulu.M 13
 Objectives of Audit
• The principal or primary objective of an audit is to
enable the auditor to gather and evaluate audit
evidence of sufficient quantity and appropriate
quality in order to form, and communicate to the users
of the financial statements an audit opinion on the truth
and fairness of the financial position and operating
results as shown by an organization.
• Based on his/her checking the auditor expresses his/her
opinion about the quality of the financial statements
concerning proper disclosure of facts and the truth and
fairness of the financial position and results of operation
of the enterprise.
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 Objectives of Audit
The secondary objectives of an audit are generally
taken to be as follows:-
Detection and prevention of errors and
Detection and prevention of frauds
• Detection and prevention of errors:
• Errors of Omission: An error of omission arises from omitting to record a transaction
fully or partially in the book of accounts.
• Errors of Commissions: An error of commission arises because of recording a
transaction incorrectly, either partially or wholly.
• Errors of Principle: An error of principle arises from the failure to observe fundamental
principles of accounting in recording the transactions.
• Errors of Duplication and Error of Compensating

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 Objectives of Audit
• Detection and prevention of frauds: A fraud is
intentionally made act of misstatement involving either
misappropriation of cash, goods or any property; or
falsification (manipulation) of accounts.
• Misappropriation (embezzlement) of cash is very easy
and can be committed by not entering a receipt, or by
entering receipt of lesser amount, or by showing fictitious
payments.
Manipulation of accounts can be made with the objective
of reducing profit or inflating profit by using some devices
like non provision of depreciation, wrong classification of
expenditures, under/over valuation of assets and non
provision of bad debt expenses.
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 Advantage and disadvantage of auditing
• Advantages:
• Audit can help in detecting and preventing errors and frauds.
• Because of the audit, book of accounts are kept, maintained
with accuracy, and up to date
• The auditors will recommend on issues, which need
improvement after completing the audit.
• The shareholders, government tax institutions and other
stakeholders will have confidence on the financial statements
of the audited business since an independent body proved it.
• Valuation of assets and liabilities becomes easy
• Audited accounts will be more acceptable to banks and other
financial institutions in obtaining funds and extending
financial accommodation.
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 Advantage and disadvantage of auditing
• Audited accounts will help in avoiding disputes between
the partners especially where profit sharing arrangements
are complex
• Audited accounts will carry greater authority for tax
assessment by tax authorities.
Disadvantage:
May not get complete or correct information or full
explanation: Auditor has to depend on the explanation and
information from the client.
An auditor is not expected to be expert in all the areas
The audit fee!
The audit involves the client’s staff and management in
giving time to providing information to the auditor.

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 Accounting and Auditing
Similarities evidence covering financial
Both are concerned with statements
accounting information Objective of accounting is to
Both accountants and auditors prepare financial statements
have considerable expertise in where as , the objective of
accounting mater. auditing is to determine fairness
of statements in conformity with
Both accounting and auditing IFRS
deliver reports to their users.
Accounting covers only
Difference quantitative data. However,
Accounting is analyzing, auditing covers both
recording classifying and quantitative and qualitative data.
summarizing events and Accounting starts where book
transactions to prepare financial keeping ends. Whereas, auditing
statements. Nevertheless, starts where accounting ends.
auditing is concerned with
obtaining
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 Purpose and Scope of Auditing
• Dependable financial information is essential to the
very existence of the society. In making a decision,
such as, to buy or sell securities, the banker deciding to
approve a loan; the government to obtain revenue based
on income tax returns etc, all are relying upon
information provided by auditors.
• There are many advantages of auditing to the modern
society. The more important of these are as follows.
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 Tool of Control over Resources

• The most advantage of auditing is that it acts as a tool of control over those
who harm resources belonging to others. In the case of government, audit
seeks to ensure that the use the public funds properly. Whenever a person
or authority is entrusted with the resources belonging to others, it becomes
necessary to exercise suitable control over such people by officials to ensure
that the resources are used properly.
• Audit can act as an important instruction of practicing such control.
Experiences of certain countries show that whenever the audit becomes
weak, there was a gross misuse of public funds. Thus, audit acts as a mere
protection against misuse of funds and reduces the possibility of errors and
frauds..

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 Tool for Enhancing Creditability of Economic Information

• Another advantage of auditing is that it enhances the credibility of economic

information, thus, the shareholders of a company would give greater reliance
on the financial statements of the company, if the auditor expresses the
opinion that these statements present a true and fair view.
• Apart from the owners, other readers of financial statements of an
enterprise also place great reliance on them if they have been audited

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 Tool for Improving Economy and Efficiency

• During examination of any type of audit, the auditor reviews the activities of the enterprise.
He/she is, therefore, often in a position to make suggestions to improve the efficiency of various
activities of the enterprise.

• Certain types of audits are carried on to review the operations and activities, so that, wastages
and losses can be minimized, weaknesses in the system can be discovered and overcome, and
control can be strengthened.

• In internal audit of operational audit or management audit the auditor generally makes
proposals for

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• During examination of any type of audit, the auditor reviews the activities of the
enterprise. He/she is, therefore, often in a position to make suggestions to improve the
efficiency of various activities of the enterprise.

• Certain types of audits are carried on to review the operations and activities, so that,
wastages and losses can be minimized, weaknesses in the system can be discovered
and overcome, and control can be strengthened.

• In internal audit of operational audit or management audit the auditor generally makes
proposals for improving the economy and efficiency within which resources are
employed. The need for most types of audit arises only after the accounting process is
completed. The auditor conducts the final product of the accounting system and
attempts to collect evidence to enable him/her to express an opinion thereon.
Therefore, in most audits, the auditors review the completed work of an accountant
from a specific outlook. Auditor's task begins where the task of the accountant ends.
The auditor should reasonably assure himself/herself that the accounting system is
adequate and that all the accounting information that should be recorded has in fact
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been recorded.
• The auditor should gain an understanding of the accounting system and related
internal controls and should study and evaluate the operation of those internal controls
upon which he wishes to help in determining the nature, timing and extent of other
audit procedures.

• Upon completing the review and testing of the accounting records, the auditors should
prepare a working paper describing the records in use, the tests of controls and other
audit procedures followed, the nature and significant misstatements discovered, any
suggestions for improving the accounting system and the auditors conclusion as to the
overall quality of accounting records.

• This working paper summarizes an important part of the auditor's consideration of

internal control and may serve as a reference for determining appropriate
modifications in the audit program. At the beginning of the next annual audit, a review
of the working paper will enable the auditors to concentrate up on the most significant
aspects of the accounting records.

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 Scope of Auditing
• The scope of auditing depends on the type of auditing performed by the
professional auditors. Hence the scope of internal and external auditing is
described as follows. The scope of internal audit activity includes examining
and evaluating the policies, procedures and systems which are in place to
ensure: reliability and integrity of information, compliance with policies,
plans, procedures, laws and regulations; safeguarding assets; economical and
efficient use of resources; and accomplishment of established objectives and
goals for operations or programs. Internal Audit may provide consulting
services within the organization concerning issues related to internal controls,
special investigations, and other areas of interest and concern. Whereas,
external audit is aimed at caring out such work as is necessary to form an
opinion as to whether:
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 Scope of Auditing
• a) The accounts are properly kept; and b) The annual financial statements: i)
are prepared in accordance with the financial records; and ii) Represent fairly
the results of the operations and the financial in accordance with the
Accounting Standards, relevant legislation and other mandatory professional
reporting requirements.
• The auditor is to include in their proposal the extent to which the critical
matters such as revenue, expenditure, assets liabilities and equities will be
audited to provide reasonable assurance of whether these items are free of
material misstatement caused either by fraud or error. The scope of
governmental auditing is to provide reasonable assurance of whether the rules
regulations and all the proclamations issued by the government is being
respected by the client.
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 Types of Audits

 Auditmay be classified in various ways. It may be classified

according to:
1. The primary beneficiary of the audit – Internal and external Audit.
2. The primary objectives of the audit –Financial statement audits,
Compliance audits, Operational audits and Forensic audits.

Auditing part I 28
 Types of Audits

Internal Vs External Audit

 Internal Audit: it is an audit conducted by employee of
an organization into any aspect of its operation.
 It is conducted for parties (usually management) internal
to the entity.
 It may be performed by personnel from an outside source
(such as an accounting firm when the service is
outsourced.).
 Internal auditors work focuses on investigation and
appraisal of the effectiveness of the company operations
for management.
Auditing part I 29
 Types of Audits

…… Internal Audit
 The Institute of Internal Auditors (IIA) defined internal
auditing as follows:
 “Internal auditing is an independent, objective assurance and
consulting activity designed to add value and improve an
organization's operations. It helps an organization accomplish
its objectives by bringing a systematic, disciplined approach to
evaluate and improve the effectiveness of risk management,
control, and governance processes”.

Auditing part I 30
 Types of Audits

…… Internal Audit
 It is conducted in accordance with management's requirement
 The requirements that may be wide-ranging or narrowly-focused,
and continuous (ongoing) or one-off in nature.
 For example, it may be as broad as investigating the appropriateness
and level of compliance with the organization’s systems of internal
control, or as narrow as examining the entity’s policies and
procedures for ensuring compliance with health and safety
regulations.

Auditing part I 31
 Types of Audits

External Audit
 It is an audit performed for parties external to the auditee.
 Experts, independent of the auditee and its personnel, conduct
these audits
 The best known and most frequently performed external audits
are statutory audits (audits carried out because the law requires
them of compliances)’ and public sector entities financial
statements (ie financial statement audits).
 Compliance audits conducted by Customs office and the
Inland Revenue are also examples of external audits.
 External audits are also described as a societal control which
serves the needs of internal and, more importantly, external
financial information users.
 External auditors conduct opinion audit
Auditing part I 32
 Types of Audits based on objective
1. Audits of Financial Statements: The goal is to
determine whether financial statements have been
prepared in conformity with specified criteria and to
provide assurance for third parties or external users that
such statements present a company's financial condition
and results of operations 'fairly'. Firms of certified public
accountants normally perform financial statement audits.
2. Compliance Audits: concerned with examining
whether government resources are used properly and
in compliance with related government rules and
regulations.
The reports of compliance audit highlight inefficiencies
and make recommendations for improving the
efficiencies
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and effectiveness
By: Mulu.M
of operations. 33
 Types of Audits
Compliance audit is conducted to determine whether
the auditee is following specific procedures, rules, or
regulations set by some higher authority.
Following are examples of compliance audits for a
private business.
 Determine whether accounting personnel are following
the procedures prescribed by the company controller.
 Review wage rates for compliance with minimum wage
laws.
 Examine contractual agreements with bankers and other
lenders to be sure the company is complying with legal
requirements.
 Governmental units, such as school districts, are subject
to considerable compliance auditing because of extensive
government
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regulation. By: Mulu.M 34
 Types of Audits
Many private and not-for-profit organizations have
prescribed policies, contractual agreements, and legal
requirements that may require compliance auditing.
Results of compliance audits are typically reported to
management, rather than outside users, because
management is the primary group concerned with the
extent of compliance with prescribed procedures and
regulations.
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 Types of Audits
3. Operational Audits: evaluates the efficiency and
effectiveness of any part of an organization’s operating
procedures and methods.
Its primary objective is to assess the quality of operations
and whether it is in line with the company’s prescribed
polices/plans
The purpose of an operational audit is to assess
performance, identify areas of improvement, and develop
recommendations.
Sometimes this type of audit is referred to as a performance
audit or management audit.
Because the criteria for effectiveness and efficiency are not
as clearly established as are generally accepted accounting
principles
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and many laws By:and
Mulu.M
regulations, an operational
36
audit tends to require more subjective judgment
 Types of Audits

4. Forensic audit
The purpose of forensic audit is the detection or
deterrence of a wide variety of fraudulent activities.
Some examples where a forensic audit might be
conducted include:
 Business or employee fraud,
 Criminal investigation, Shareholder or partnership
disputes,
 Business economic losses and Matrimonial
disputes (divorce proceedings).
Auditing part I 37
 Types of auditors
1. Internal Auditors: all organization including
governmental and non-governmental maintains internal
auditors.

A principal goal of the internal auditors is to investigate

and evaluate the effectiveness with which the various
organizational units of the company are carrying out their
assigned functions.
Much attention is given for internal auditors to the study
and appraisal of internal control.
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 Types of auditors
The Institute of Internal Auditors (IIA) of US has
developed a set of standards that should be followed by
internal auditors and has established a certification
program.
An individual meeting the certification requirements
set by the IIA, which includes passing a uniform
written examination, can become a certified internal
auditor (CIA).
internal auditors must be objective and independent.
To help ensure the objectivity and independence of
internal auditors, the IIA suggests that the director of
internal auditing report directly to either the board of
directors or the audit committee of the board or have free
access
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to the board. By: Mulu.M 39
 Types of auditors
Regardless of their reporting level, however, internal
auditors are not independent in the same sense as
external (independent) auditors.
The internal auditors are employees of the company
in which they work, subject to the restraints inherent
in the employer – employee relationship
Internal auditors can be involved in all three types of
audits.
Their primary activities are to conduct compliance and
operational audits within their organization.
They also engage in testing whether the firm is
undertaking its activities and using its resources
efficiently and effectively to achieve its objectives.
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 Types of auditors
Unlike the external auditors, who are committed to verify
cash significant item in the annual financial statements,
the internal auditors are not obliged to repeat their
audits on an annual basis.
However, they may also assist the external auditors with the
annual financial statement audit
While external auditor (CPA) concentrates on an overall
evaluation of financial statements submitted to the third
parties, the internal auditor is more concerned with the
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 Types of auditors
2. External (independent) Auditors: They are called
independent auditors or certified public accountants
Such auditors are called "external" because they are not
employed by the organization being audited.
It might even be said that their basic task is to confirm to
the owners that the employees are correctly reporting on
their own financial performance.
The independent auditor is responsible primarily to third
parties (users of financial statements such as investors,
bankers, government, financial analysts, stock exchanges
and other agencies).

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 Types of auditors
An external auditor conducts financial statement audits
for publicly traded and private companies, partnerships,
municipalities, individuals and other types of entities.
They may also conduct compliance and operational audits
for such entities.
An external auditor may practice as a sole proprietor or as
a member of a CPA firm.
Professional standards require that external auditors
should maintain their objectivity and independence when
providing auditing or other attestation services for
clients.

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 Types of auditors
3. Government Auditors: aims to ensure accountability of the
executive in respect of public revenue and expenditure.
The objective of Government auditing is that of systematic,
professional and independent examination of financial,
administrative and other operations of a public entity made
subsequently to their execution for the purpose of evaluating
and verifying them, presenting a report containing
explanatory comments on audit findings together with
conclusions
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and recommendations
By: Mulu.M
for future actions. 44
 Types of auditors
In order to achieve their objectives governments have
established their own auditors called government auditors
having their own independent offices.
For instance, the federal government auditors of United
States of America are called General Accounting Office
(GAO) auditors.
The work of GAO auditors includes compliance,
operational and financial audits.
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 Types of auditors
The GAO audits the financial statements of a number of
federal agencies and the consolidated financial statements
of the federal government.
GAO is responsible to the legislature, or executive, but
ultimately to the taxpayers.
GAO auditors perform all Compliance Audits.

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The Relationship between the type of Auditors and Audit types
AUDITS OF
OPERATIONAL COMPLIANCE FINANCIAL
AUDITS AUDITS STATEMENTS

PURPOSE To evaluate whether To determine whether the To determine whether

operating procedures are client is following specific the overall financial
efficient and effective procedures set by higher statements are presented
authority in accordance with
specified criteria (usually
GAAP)

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The Relationship between the type of Auditors and Audit types
AUDITS OF
OPERATIONAL COMPLIANCE FINANCIAL
AUDITS AUDITS STATEMENTS

USERS OF AUDIT Management of Authority setting down Different groups for

REPORT organization procedures, internal or different purposes —
external many outside entities

NATURE Highly nonstandard; Not standardized, but Highly standardized

often subjective specific and usually
objective

PERFORMED BY:

CPAs
Frequently Occasionally Almost universally

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