UNIT 1: OVERVIEW OF AUDITING

Contents
1.0 Aims and Objective
1.1 Introduction
1.2 Over view of Auditing
1.2.1 Definition
1.2.2 Demand for Audit
1.2.3 Internal Auditing
1.3 Types of Auditing
1.3.1 Financial Statement Audits
1.3.2 Compliance Audits
1.3.3 Operational Audits
1.4 Summary
1.5 Glossary
1.6 Answers to Check Your Progress
1.7 Model Examination Questions

1.0 AIMS AND OBJECTIVES

After studying this unit, you should be able to:

- explain the meaning of Auditing
- explain the need for Auditing
- explain Internal Auditing, and
- identify the types of Audits.

1.1 INTRODUCTION

This unit deals with the definition of Auditing, why there is a demand for Auditing by stock
holders, managers, employees, and debt holders, what is the role of Internal Auditing in an
organization; and deals with description of types of Audits commonly used by the
professional Auditors.

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The public accounting profession (CPA), as we knew it today grew mainly out of the
demand for financial statement Audits. Very specific auditing standards, referred to as
generally accepted auditing standards (GAAS), are provided for conducting financial
statement audits. How ever, In recent years, the profession has been asked to provide services
beyond the traditional financial Statement Audit. These include compliance and operational
Audits.

1.2. OVERVIEW OF AUDITING

1.2.1 Definition of Auditing

The American Accounting Association, committee on Basic Auditing concepts - Defined
Auditing as:

Auditing is systematic process of objectively obtaining and evaluating evidence regarding

assertions about economic actions and events to ascertain the degree of correspondence
between assertions and established criteria and communicating the results to interested users.

The phrases in this definition require additional explanation. The phrase systematic process
implies there should be a well-planned approach for conducting an audit. This plan involves
objectively obtaining and evaluating evidence. The evidence gathered by the auditor must
relate to assertions about economic actions and events. For example. Financial statements
prepared by management contain numerous assertions. If the Balance sheet contains amount
of Br. 10million for property, plant and equipment, management is asserting (declaring) that
the company owns the assts, uses them in the production of goods and services, and that this
amount represents their un depreciated historical costs. The Auditor compares the evidence
gathered to assertions about economic activity in order to assess the degree of correspondence
between those assertions and established criteria. Generally Accepted Accounting Principles
(GAAP) are normally used for measuring the degree of correspondence, for financial Audits.
The last Phrase, communicating the results to interested Users, is concerned with the type of
report the auditor provides to the intended users. (Banker, investors, stockholders, Creditors,
e.t.c ).

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1.2.2 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 – audits whether 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.

(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-partian) 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 in formation & translation has been
come 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, memo random of association and
government regulation, make requirements’ annual audits. For Example –For

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 renewal of license, or permit, (commercial code to Ethiopia), financial
Administration regulation proclamation tax, requires audited financial statements.

1.2.3. Internal Auditing

Internal auditing is a managerial control activity performed with an organization as service to
management by an employee of the organization. It reviews operations through the
measurement and evaluation of other control mechanisms. Their primary activities are to
conduct compliance and operational audits within the organization. However, they assist the
external auditor with the annual financial statement audit. Internal auditors are employed by
Individual companies, partnerships, government agencies. The Institute of Internal Auditors
(IIA) has developed set of standards that should be followed by Internal auditors and
Established certification program – which Includes passing of uniform writer examination.
Like external auditors they must be Independent and objective.

1.3 TYPES OF AUDIT

While there are many types of audit based on the definitions previously provided, generally
they are discussed under three types: financial statement audits, compliance audits and
operational audits

1.3.1 Financial Statement Audits

The purpose of a financial statement audit is to determine whether the overall financial
statements present fairly in accordance with specified criteria. This type of audit usually
covers the basic set of financial statements (Balance sheet, Income statement, statement of
stockholders equity, and statement of cash flows); and Generally Accepted Accounting
principles (GAAP) serve as the criteria. However, certain financial statements audits may use
of other criteria, such as cash basis or Income tax basis.

1.3.2 Compliance Audits

The purpose of a compliance audit is to determine the extent to which rules, policies, Laws
covenants, or governmental regulation are followed by the entity being audited for example,
accompany may use auditors to determine whether the corporate rules, and policies are being
followed by departments within the organization. The corporate rules and policies serve as

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the criteria for measuring the departments Compliance. Another example is examination of
tax returns (payment) of individuals and companies by the Internal Revenue Service for
compliance with Tax Laws.

1.3.3 Operational Audits

Operational Audit involves a systemic review of organizational activities, or apart of them, in
relation to the efficient and effective use of resources. The purpose of operational audit is to
assess performance, Identity areas of Improvement, and develop recommendations.
Sometimes this type of audit is referred to as a performance audit or management audit.
Operational audits are generally more difficult to conduct than financial and compliance
audits. Since the purpose of an operational audit is to assess effectiveness and efficiency, it
can be very difficult to Identify objective, measurable criteria that can be used for that
purpose.

Examples of such audit include – audit of government programs, Efficiency of the food and
Drug administrations procedures for Introduction of new Drugs, to market. Assessment of the
efficiency and effectiveness of organizations use of computer resources. etc.

Check Your Progress Exercise

1. Discus what leads to the demand for auditing services in a free market economy.
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2. Define the three general types of audits.
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3. What does the phrase systemic process means in the Auditing definition?
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4. List the established criteria other than GAAP that can be used to measure economic
information.
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1.4. SUMMARY

The primary reason for development of Auditing profession is the need of attest function.
That is, the need of Independent assurance of the reliability, credibility and quality of
Information. When certified public accountants attest to information they issue a report with
a conclusion about the reliability of a written assertion by management. In the case of
financial statement Audits, the Audit report most frequently includes an opinion about
whether management is financial statements conform to generally accepted accounting
principles. Auditors also are being asked to assume more responsibility for attesting to
compliance with laws and regulations, and to the effectiveness and Internal controls.

1.5. GLOSSARY

1. Assertion - are presentation or declaration, typically made by the management of

entity.
2. Certified public Accountant (CPA) – A person licensed by the state to practice public
accounting is a professions, based on having passed the uniform CPA Examination and
having met certain educational and experience requirements.
3. Compliance Audit- An audit to maser the compliance of the organization with some
established criteria, for example, Laws and regulation.
4. Operational Audit- An analysis of department or other unit of business or
governmental organization to masseurs the effectiveness and efficiency of operation.

1.6. ANSWERS TO CHEEK YOUR PROGRAM QUESTION

1. The demand for Auditing in the free market economy economy among other include:
- Control mechanism - to minimize bad consequences from the decisions

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 - to resole conflict of interest - to simplify completive
- to meet the regulatory requirements
2. The three general types of Audit are
a) Financial statements Audit b) compliance Audit and c) operational Audits
3. Systematic process in Auditing means that fuere should be a well – designed audit plan
to conduct an actual Audit.
4. These measuring criteria Include Laws and regulations, for compliance Audit; Plans and
standards or policies, programs, budgets, for operational Audits.

1.7 MODEL EXAMINATION QUESTIONS

Instruction – choose the best answer for the following questions.

1. Independent Auditing can be best be described as:
A. A branch of accounting
B. A discipline which attests to the result ‘s of accounting and other functional operations
and data.
C. A professional activity that measures and communicates financial and business data.
D. A regulatory function that prevents the issuance of Improper financial information.
2. An Independent Audit aids in the communication of economic data because the audit.
A. Confirms the accuracy of management of financial representations.
B. Lends credibility to the financial statements
C. Guarantees that financial data are fairly presented.
D. Assures the readers of financials that any fraudent activity has been corrected.
3. Operational auditing is oriented primarily toward:
A. Future improvements to accomplish the goals of management.
B. The accuracy of data reflected in managements financial records.
C. Verification that the company’s financial statements are fairly
presented.
D. Past protection provided by existing Internal control
4. A typical objective of operational Audit is to determine whether an entities.
A. Internal control is adequately operating as designed.

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 B. Operational Information is in accordance with generally accepted
governmental standards.
C. Financial statements present fairly the results of operations.
D. Specific operating units are functioning efficiently and effectively.
5. Which of the following best describes the reason why an Independent auditor reports
an financial statements:
A. a management fraud may exist, and It is more likely to be defected by
Independent auditors.
B. Different Interest may exist between the company preparing the
statements and the persons using the statements.
C. A misstatement of account balances may exist, and It is generally
corrected as result of the Independent auditors work.