Chapter One
The Nature, Purpose, Scope of Audit and Assurance Services
1.1. Meaning of Audit
What is Auditing?
The term auditing is used to describe a broad range of activities in the modern society. In order to
understand what an audit is and how it is conducted in the modern context, a definition is needed. A
comprehensive definition of auditing with general application is as follows;
Auditing is a systematic process of objectively obtaining and evaluating evidence regarding
assertions about economic actions and events to ascertain the degree of correspondence between
those assertions and established criteria, and communicating the results to interested users.
Several attributes of auditing contained in this definition merit special comment:
Auditing is a systematic process: Process implies that auditing is a dynamic ongoing activity which
is not a one-time check of the relationship between financial assertions and underlying events. On the
other hand, the word systematic indicates that auditing is an objective and logical process based on
scientific approach to decision-making.
Objectively obtaining and evaluating evidence: Auditors should gather and evaluate sufficient
evidence to arrive at a reasonable conclusion concerning the financial statements. This definition
requires auditors to be unbiased and objective in doing so.
Regarding assertions about economic actions and events: Assertions are propositions about the
accounts, amounts and other information appearing on the financial statements which the company
management claims to be accurate. The definition indicates that the auditor’s responsibility is to verify
these assertions or management representations.
Degree of correspondence: Refers to the closeness with which the assertions can be identified with
established criteria. The expression of correspondence may be quantified, such as the amount of a
shortage in a petty cash fund, or it may be qualitative, such as the fairness of financial statements.
Established criteria: This phrase specifies that there should be established criteria against which the
assertions or representations are to be evaluated. The established criteria may be a legislative body,
budgets and other measure of performance set by management, or International Financial Reporting
Standards (IFRS), legislations, or government regulatory agency pronouncements.
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Communicating results: is achieved through a written report that indicates the degree of
correspondence between the assertions and established criteria. The communication of results either
enhances or weakness the credibility to management’s representations so that interested users can use
the information with reasonable assurance that it is free of material misstatement. As any other
process, auditing involves input and output. The input being financial information, the process is
examination and the final output is a report containing an auditor’s opinion.
Interested users are individuals who use (rely on) the auditors findings. In a business environment,
they include stockholders, management, creditors, government agencies, and the public.
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 transactions 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 results 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
transactions by vouching all the relevant documentary evidence at his disposal.
Auditing, thus primarily involves testing the reliability, competency and adequacy of evidence in
support of monetary transactions of an organization. It is the process of testing and weighing of
evidence.
Auditing is analytical, critical and investigative. It has its principal 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 implemented audit program helps an auditor to arrive at proper conclusions regarding
the accounting statements and thus helps him to formulate his opinion.
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ACCOUNTING Vs AUDITING
Accounting is a process of recording, classifying summarizing and communicating financial activities
of an entity. Accountants must have a thorough understanding of the principles and rules of preparing
financial statements- International Financial Reporting Standards (IFRS). They develop a system to
make sure that the entity’s economic events are properly recorded on a timely basis and at a reasonable
cost.
Auditing is concerned with determining whether recorded information properly reflects the economic
events of the entity. An auditor must also understand those principles and rules (IFRS). Auditors must
have knowledge and expertise in the collection and interpretation of audit evidence. This expertise
distinguishes auditors from accountants. Moreover, determining proper audit procedures, sample size,
items to examine, timing of tests, and evaluating the results are problems unique to an auditor.
Thus, an auditor can also work as an accountant since s/he knows the recording principles and
rules. However, an accountant cannot act as an auditor since s/he lacks the expertise mentioned
above. To become an auditor, an accountant has to get additional training and certificate of competence
from a recognized professional association. Accounting is a creative process while auditing is a critical
(evaluative) process.
1.2. Assurance Services: Overview
An assurance service is an independent professional service that improves the quality of
information for decision makers. Such services are valued because the assurance provider is
independent and perceived as being unbiased with respect to the information examined.
Individuals who are responsible for making business decisions seek assurance services to help
improve the reliability and relevance of the information used as the basis for their decisions.
For example, Consumers Union, a nonprofit organization, tests a wide variety of products used
by consumers and reports their evaluations of the quality of the products tested in Consumer
Reports. The organization provides the information to help consumers make intelligent decisions
about the products they buy. Many consumers consider the information in Consumer Reports
more reliable than information provided by the product manufacturers because Consumers Union
is independent of the manufacturers. Similarly, the Better Business Bureau (BBB) online
reliability program, the BBB Accredited Business Seal, allows Web shoppers to check BBB
information about a company and be assured the company will stand behind its service. Other
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assurance services provided by firms other than CPAs include the Nielsen television and Internet
ratings and Arbitron radio ratings. The need for assurance is not new. CPAs have provided many
assurance services for years, particularly assurances about historical financial statement
information. As a result of provisions in Section 404 of the Sarbanes–Oxley Act, CPA firms
provide assurance on internal control over financial reporting for larger public companies.
More recently, CPAs have expanded the types of assurance services they perform to include
other information of interest to investors, customers, and other interested parties, such as reports
on corporate social responsibility and sustainability reports. For example, businesses and
consumers often seek assurances that companies with which they conduct business produce
products and services in a socially responsible manner.
The demand for assurance services continues to grow as shareholders and other stakeholders
seek assurances about financial and nonfinancial information in addition to information in
corporate financial reports.
One category of assurance services provided by CPAs is attestation services. An attestation
service is a type of assurance service in which the CPA firm issues a report about a subject
matter or assertion that is made by another party. Primary categories of attestation services
include:
Audit of historical financial statements
Audit of internal control over financial reporting
Review of historical financial statements
Other attestation services that may be applied to a broad range of subject matter
[Link] Audits are conducted
Most business entities employ accountants and bookkeepers to process the transactions and financial
statements. Nevertheless, there is still demand for audit for the following reasons.
Conflict of interest: Users of financial statements may have diverse interests in the reporting entity,
and their interest may not coincide with the interest of those who have prepared the data. Many users
are particularly concerned about an actual or potential conflict of interest between themselves and the
managements of the entity. This worry extends to the fear that the financial statements and
accompanying data that management is providing may be intentionally or unintentionally biased by
the provider. Thus, users seek assurance from outside independent experts that the data are free from
the perceived conflict of interest.
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Consequences of error: Financial statements are the major source of information for decision
making by users. In making significant decisions such as lending, investments, and other decisions,
users want the financial statements to contain as much relevant data as possible. The independent
auditor gives reasonable assurance to the users that the financial statements are prepared in
conformity with Reporting standards (IFRS/GAAP).
Complexity: Both the subject matter of accounting and the process of preparing financial statements
are becoming more and more complicated. As the subject matter becomes more complicated, there is
a greater risk of misinterpretation and a greater possibility of an unintentional error. Users,
therefore, are finding it more difficult or even impossible to evaluate the quality of the statement.
Thus, they need the independent auditor for assurance about the quality of the information being
received.
Remoteness: Few users have direct access to the accounting records from which financial statements
are prepared. Furthermore, in instances when records are available for scrutiny, time and cost
constraints normally prevent users from making meaningful examinations. Remoteness prevents users
from directly assessing the quality of the statements. Thus, the auditor serves as a link by providing
an objective and unbiased opinion on the financial statements.
Regulatory requirements (statutory requirements): Some organizations are legally required to get
their financial statements audited. For instance, the 1960 Commercial Code of Ethiopia requires any
share company in Ethiopia to get books of accounts audited annually so as to renew their license.
From the above discussions, you must have understood why auditing is needed. The contribution of
auditing is not limited to individuals as it is also useful to the society. Below, we have outlined some
of the advantages of auditing for the society:
It serves as a controlling tool over those who handle resources belonging to others: When
a person or an authority is assigned to run an organization using resources that belong to
others, it becomes necessary to exercise a suitable control over such person or authority to
ensure that the resources are used properly. Audit acts as an important means of control.
If employees know that the accounts will be audited, they will be cautious since they fear that
any errors and fraud will be discovered. In this case, audit is also used as a means of
preventing misuse of resources and reducing errors and frauds.
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Audit increases credibility of financial information: The degree of reliance placed on
audited financial statements is greater than that of unaudited financial statements. This is
because the auditor is an independent and impartial person that has no stake in the management
of the entity under audit. Thus, users of the financial information would place greater reliance
on the financial statements if the auditor expresses the opinion that the statements present fairly
the picture of the entity.
Audit enhances efficient utilization of resources: In conducting any type of audit, the auditor
reviews the activities of the entity with a view to identifying strengths and weaknesses.
Therefore, the auditor gives suggestions and recommendations so that wastages and losses of
resources can be minimized. For example, in an operational audit, the auditor makes
recommendations for improving the economy and efficiency with which resources are used.
Though auditing has the above advantages along with others, auditing has its own limitations.
Some of these limitations are:
Its opinion is based on sampling. i.e... It does not look at 100% of transactions
It cannot predict future events
It may fail to detect fraudulent transactions (management fraud).
Evidence obtained is persuasive, rather than conclusive
Provides reasonable assurance, not absolute assurance
The inherent limitation in accounting still exists in auditing.
1.4. TYPES OF AUDIT AND AUDITORS
1.4.1. Types of Audits
There are different types of audits conducted by different types of auditors. Such difference is based
on the scope and objective of the audit and employment of the auditors. Based on audit objective,
audits can be classified as financial statement audit, operational audit, compliance audit and
Forensic audit.
1. Financial Statement Audit
The financial statement audit involves obtaining and evaluating evidence about an entity’s
presentation of its financial position, results of operations and cash flows for the purpose of
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expressing an opinion on whether they are presented fairly in conformity with established
criteria_(IFRS).Financial statement audits are normally performed by authorized auditors (CPA,
ACCA).and the company whose financial statements are being audited usually hires the external
audit firm. The users of financial statement audit include managements, investors, bankers, creditors,
financial analysts, and government agencies. In addition, the external auditor also prepares a report to
the audit committee of the board of directors about the company’s accounting policies, internal
controls and other findings.
Many lenders and creditors rely on financial statement audits to obtain assurance about the reliability
of information used to support lending decisions. High quality financial audits significantly reduce
the risk that investors and creditors will use poor-quality information when making a variety of
investment decisions. The end product of a financial statement audit is an auditor’s report through
which the auditor expresses his/her opinion. There are four types of audit reports /opinions/; namely,
Unqualified, Qualified, Adverse, and Disclaimer.
2. Compliance Audit
A compliance audit involves obtaining and evaluating evidence to determine whether certain financial
or operating activities of an entity confirm to specified conditions, rules, or regulations. The established
criteria in this type of audit may come from a variety of sources. The objective of compliance audit is
to determine whether the organization being audited following procedures, regulations, or policies is
established by a higher authority. Performance of compliance audit is dependent on the existence of
verifiable data and of recognized criteria or standards, such as laws and regulations, or an
organization’s polices and regulations. A common example is the audit of income tax return by an
auditor of the internal revenue authority. The tax auditor checks whether the tax return is in compliance
with tax laws and regulations.
3. Operational /performance/ Audit
Operational audit is a study of some specific unit of an organization for the purpose of measuring its
performance. For example, you may be assigned to evaluate the performance of the operations of the
receiving department of a merchandising business in terms of its effectiveness and efficiency. An
operational audit reviews the organization or a unit’s activities to assess performance, to identify
opportunities for improvement, and to suggest recommendations for further action. An operational
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audit focuses on such matters as goals, objectives, policies, organizational structures, functions and cost
effectiveness. Some of the functions of an operational audit are:
o Planning the work to be performed including the setting of standards by which the audit is to
be evaluated;
o Gathering evidence to measure the performance of the operation;
o Analyzing and investigating deviations;
o Suggesting corrective actions, where needed, and
o Reporting the results to the appropriate level of management.
Generally, operational audit helps the organization to effectively allocate resources, identify problems
at an early stage, improve communication, and increase profitability.
An operational audit requires subjective judgment since the criteria for effectiveness and efficiency
are not as clearly established as are IFRS or tax regulations. The end product of an operational audit
is usually a report to top management containing recommendations for improvements in operations.
4. Forensic audit
A forensic audit’s purpose is the detection or deterrence of a wide variety of fraudulent activities.
Some of the examples where a forensic audit might be conducted include:
Business or employee fraud Business economic losses
criminal investigations Matrimonial disputes.
shareholders and partners disputes
1.4.2. TYPES OF AUDITORS
Individuals engaged in auditing are generally classified in to three groups: independent auditors
(external auditors), internal auditors, and government auditors. A brief description of each group and
the types of auditing done by each is given below.
1. Independent (External) Auditor
An independent auditor, also known as certified public accountant or external auditor, has no
connection to the organization being audited. Independent auditor conducts the audit on a fee basis,
and is primarily responsible to third parties-creditors and shareholders. The type of audit carried out
by an independent auditor is financial statement audit.
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Independent auditors are usually CPAs who are either individual practitioners or members of public
accounting firms who render professional auditing service to clients. In general licensing involves
passing the uniform CPA (ACCA) examination and obtaining practical experience in auditing. In
Ethiopia, the authorized auditors perform financial statement audit. In addition, the Audit Service
Corporation, a government-owned organization, performs financial statement audit.
2. Internal Auditor
Internal auditors are employees of the companies they audit. This type of auditor is involved in an
independent appraisal activity, often known as internal auditing, within an organization as a service to
the organization. The objective of internal auditing is to assist the management of the organization in
the effective discharge of its responsibilities. The attainment of this overall objective involves such
activities as:
Reviewing and appraising the soundness, adequacy, and application of accounting, financial,
and other operating controls, and promoting effective control at a reasonable cost;
Ascertaining the extent of compliance with established policies, plans, and procedures;
Ascertaining the extent to which company assets are accounted for and safeguarded from
losses of all kinds;
Ascertaining the reliability of management data developed within the organizations;
Appraising the quality of performance in completing assigned responsibilities;
Recommending operating improvements;
The scope of the internal audit function extends to all of the organization’s activities. (Internal
auditors are primarily involved in compliance and operational audits).
3. Government Auditor
Government auditors are employed by various local, state, and federal governmental agencies. They
conduct comprehensive audits which combine elements of financial report, compliance and
performance auditing. At the federal level, the three primary agencies are the Office of Auditor
General, the Audit Service Corporation, and Ethiopian Revenue and Customs Authority. The Office of
Auditor General is a federal organization headed by the Auditor General. This office is responsible for
conducting financial statement audit, compliance audit and operational audit of various Federal
Government Offices. The regional governments have also their own regional audit bureau with similar
functions.
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Ethiopian Revenue and Customs Authority is responsible for administering the federal tax laws. Thus,
the authority’s auditors audit the returns of taxpayers for compliance with applicable tax laws. That is,
the auditors examine the tax returns of the taxpayer to ensure that it is prepared in accordance with the
tax laws and regulations. The authority’s auditors are known as tax auditors.
Another government organ that performs audit is the Audit Service Corporation. The Audit Service
Corporation audits the financial statements of the public enterprises. Thus, the type of audit performed
by the Audit Service Corporation is financial statement audit.
4. Forensic Auditors
Are auditors employed by Corporations, government agencies and public accounting, consulting and
investigative services firms? They are trained in detecting, investigating, and deterring fraud and
white- collar crime. Some examples of their activities
Analyzing financial transactions involving unauthorized transfers of cash between companies
Proving money- laundering activities by reconstructing cash transactions,
Investigating and documenting embezzlement, and negotiating insurance settlements.
The difference and similarities among the various types of auditors is summarized in table 2 below:
Table: Comparison of Different Types of Auditors
EXTERNAL INTERNAL GOVERNMENT
AUDITORS AUDITORS AUDITORS
CPAs who are hired Company employees Local, State or Federal
as independent contractors who audit their own employees who audit various
by many different companies. company exclusively governmental organization
Perform mostly Perform mostly Perform mostly
Financial statement audits. Operational audits. Compliance audits.
Examines all or part of organization’s Examine pesons or
Examine financial statements.
activates. entity’s actions.
Criteria are the efficiency Criteria are policies,
Criterion is
And/or effectiveness of the company’s codes, laws, regulations,
IFRS/GAAP
operations. etc.
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Report on fairness of financial
Report on recommended Report on compliance
Statement in
improvements. with criteria.
conformity with IFRS/GAAP
Report goes to many Report usually goes to the company Report usually goes
different types of users itself. to a specific agency.
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